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Avoid a nasty business break-upBy Kevin Palmersheim
I often counsel business clients that going into a partnership has similarities to getting married. In the beginning, no one anticipates a marriage will end in divorce, other than perhaps your ex-mother-in-law. Unfortunately, divorce happens. Business partnerships also frequently break up. This can be for non-compatibility issues, financial issues, or disagreement on how the company should operate. A buy-sell agreement operates as the business version of a prenuptial agreement. A buy-sell can take different forms: a partnership agreement, a shareholder agreement (for corporations) or an operating agreement (for limited liability companies) are most common. A well-drafted agreement will address what happens if a partner dies, becomes disabled, or if your partner wants to leave you for a more wealthy MBA with a well-developed business plan. Here are some of the items a business partner should consider for a buy-sell agreement in order to avoid costly litigation and the possible loss of the business investment: 1. Protect against being forced out and plan for a voluntary escape Businesses are generally governed by majority rule in the absence of written protections. This is especially the case in corporations and LLCs where the shareholders or members can effectively remove minority owners with little legal recourse. Even in businesses with equal "partners," if one person is the corporate president or managing member of the LLC, he or she may terminate the employment of the other partner. Drafting protections under an agreement can thwart this squeeze-out scenario. 2. Minimum distributions to cover taxes One misconception about business income is that the owners are entitled to receive payment of their share of the profits. If distributions are made, they must be made to all owners (not including salary or other compensation for actual labor). But the company is not required to distribute profits and can retain the money for future growth. Regardless, if the company shows a net income each partner generally has to pay tax on his or her pro rata share of that income whether the money is received or not. Agreements can authorize a minimum distribution to cover tax liability. 3. First right of refusal and veto rights on new members Ownership in a business is usually transferable, unless transfer is specifically restricted by agreement. You may think you are marrying Cinderella, but when she gets a nice offer to cash out and move to a bigger castle you could be stuck married to the wicked stepsister or ne'er-do-well stepbrother. Generally, an effective buy-sell agreement includes a provision allowing you to match any offer to buy your partner's ownership interest. Alternatively, the agreement may require a partner leaving the business to sell the ownership interest back to the remaining partners. 4. Managing the breakup One of the weaknesses I see in many buy-sell agreements is the failure to provide a way out of a deteriorating relationship. A good agreement will have flexible divorce strategies. One option I use for some two-person partnerships is a "chocolate cake" provision. This is modeled after the childhood approach to sharing the last piece of chocolate cake with your sibling. Mom instructed one child to slice the cake and the other sibling was granted first choice, thereby promoting the fairest possible division. In the business setting, the chocolate cake provision is triggered when one partner wants to split up. That person names a price for the business. The other partner elects whether to buy or sell at that price. The person setting the price will be as fair as possible because it is not known whether he or she will be buying or selling at that price. In other agreements, you can have a variety of voluntary and involuntary divorce provisions that trigger a buyout of one of the partners. Under those circumstances the biggest difficulty becomes calculating the purchase price. 5. Establishing a purchase price Valuing a closely-held business is difficult. However, it is far easier to consider this issue while the relationship is in good standing than when the parties' relationship resembles the War of the Roses. A "formula" purchase price based on revenues or income is one option. This is often used for established business or service businesses where revenues or income may be the best predictor of the business' value. Alternatively, the partners can agree to set the value on an annual basis. I recommend a backup method when determining the purchase price based on consensus because the partners frequently fail to regularly adjust the value once they get busy with day-to-day operations. The usual backup method is an appraisal value. Appraisals can be expensive, time consuming and not reflective of fair market value, so they may not be the best primary valuation method. Appraisers typically apply discounts to an individual partner's ownership in a business because it represents only a part of the business and because there is not a market for the sale of partial business ownership. These discounts can often reduce the value by 30-40 percent. However, a buy-sell agreement can eliminate or restrict these discounts. The buy-sell agreement cannot plan for every contingency, but it can provide guidelines. Moreover, the parties are always free to reach an agreement different from what is written. The benefit of the agreement may be that neither party wants to resort to the contractual language and prefer to work out something amicably. Without an agreement, however, one or both partners is often stuck. This results not only in bad feelings, but often expensive litigation or the possible demise of the business. A buy-sell agreement can help avoid these costs and possibly an even greater worst-case scenario - being forced to move in with your mother-in-law. Kevin Palmersheim is an attorney with Haley Palmersheim, S.C., concentrating his practice in the areas of business law and business litigation. He can be reached at 608-836-6400. palmersheim@hplawoffice.com madison.com ©2009 Capital Newspapers. All rights reserved. |
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