Covid-19 has fostered a wave of innovation that has accelerated a growing trend toward entrepreneurship. If you’re riding that entrepreneurial wave, you’re likely exhilarated as you join with partners and create a vision for your successful new business venture.
Your enthusiasm and commitment notwithstanding, there’s one caveat: Take a moment to ensure that your planning has taken into account potential future contingencies like partner exits. What if one partner wants to leave the partnership, gets a buyout offer for their share, or gets sick, disabled or dies. If there’s no plan in place, events like these can sink your business.
Unfortunately, at the start of a business, many business partners fail to consider these possibilities. They’re unaware of the irreparable damage they can cause to the relationships among the owners, the families of the owners and to the business itself.
Begin with the end in mind. Establish goals that will help you deliver on your vision and have a plan in place for the inevitable challenges that will occur.
Businesses, especially those with multiple owners, require a business continuity plan. Potential partner exits are one of the issues a continuity plan addresses. That plan is a partnership agreement established with the help of your business attorney before your business opens its doors. More commonly referred to as a buy-sell agreement, the agreement establishes the procedures that will be followed to protect each of the owners’ interests in the company, as well as the survival and continuity of the business.
In addition to partner exit strategy, your buy-sell agreement covers all aspects of the business:
Þ Management structure
Þ Partner rights and duties
Þ The authority to make decisions
Þ Individual partner contributions of both sweat and monetary equity
Þ Allocation of losses and profits
Þ What to do if a partner becomes sick or disabled
Þ Procedures involving disputes
Adding a contingency for a partner’s exit does not mean you’re entering your partnership focusing on failure. Rather, it is a commonsense addition that includes the assumption that at some point the partnership may likely end. Partners and businesses can and do change over time. Your buy-sell agreement allows for change as well as growth.
Several common exit scenarios could threaten the continuity of the business.
#1 A Partner Wants to Leave the Business
The immediate questions that arise in this situation can be managed by a buy-sell agreement.
- Can the partner leave without notice and demand a full pay out?
- Does the company have to pay the partner?
- If so, how much must the company pay and how soon?
A good buy-sell agreement will outline how to determine the compensation for the exiting partner’s shares or interests. Even at the outset, the agreement identifies a pre-arranged valuation method. The partnership exit agreement should also cover how to set a price if you want to buy back the departing partner’s interest. Suppose you’re in a three-person partnership with equal shares. If one partner wants to sell out, you must establish the value of one-third of the business.
The agreement lays out the structural ground rules applied to the value of your business. Now, that value undoubtedly reflects growth. A departing partner may lobby for compensation based on the value that that partner believes they have brought to the business. If that partner contributed to the business significantly or more than the others, their exit may initially diminish business value. Their compensation, therefore, may be more than the amount resulting from a simple, 3-way split. To avoid having to take too much cash out of the business, an agreement might spell out a gradual transition process rather than an immediate departure.
If you can’t reach an agreement on price, you have to compromise, say, perhaps identifying each partner’s target price and averaging them. In establishing how departing partners are paid, your agreement should also address future cash flow problems that could result from your partner’s exit. A lump-sum payment is easiest, but it may be too costly. For the sake of the business, your buy-sell agreement could establish installments as a preferable payment method.
#2 An Outsider Offers To But Out One Partner
The first question that arises in this circumstance is whether the other partners must permit the sale of the partner’s interest. On the one hand, the partners may want their interests to be freely transferrable and not be shackled by illiquidity of their interests. On the other hand, the remaining partners may not want to do business with a stranger with whom they have no prior relationship. A well-drafted buy-sell agreement will address this situation by providing guidance on whether such a third-party sale is permissible and how the transaction should be effectuated.
The agreement can also provide a fair and reasonable method for sale of the interest, commonly including a right for the company to buy the interest prior to a sale to the third party.
#3 A Partner Dies or Becomes Disabled
This is one of the key situations in which a buy-sell agreement is critical. Most business owners would want their business to continue and not terminate with the death of a partner. How do you ensure this happens and that the death doesn’t hamstring the company and make you unable to take necessary action for the business?
In many states, it is common for a deceased business owner’s interests in the business to pass to a spouse and/or children upon death. Such a forced new partnership can be a threat to the business if the deceased owner’s spouse or children know nothing about—and may not have interest in—the business. A skillfully drafted buy-sell agreement will ensure business continuity by creating a procedure for payout to the deceased owner’s beneficiaries. A buy-sell agreement could, for example, mandate insurance policies on the partners to ensure that upon the death of a partner, cash would be available to buy out the deceased partner’s beneficiaries.
A disability insurance provision can also work to address the situation of a partner becoming disabled. The policy would compensate the disabled partner and their family to prevent the remaining active partners from diverting cash from the business. Disablement presents a slightly more complex situation than the death of a partner and will require a coordination of benefits. Establishing a reentry provision is also wise as the partner may recover from their disability and want to return to the business.
Tools and a Course for the Future
A skillfully crafted buy-sell agreement accounts for a realm of future business possibilities, in particular the unexpected exit of a partner. It provides the important tools and an operating procedure to apply to your current situation and your current company valuation. Unequivocally, without a plan, an unexpected partner exit could upend your business.
At GARZA, we understand that buy-sell agreements are crucial to your company’s strategy. When you begin with the end in mind, and start with goals and a plan for contingencies, you’re bulletproofing your business against a situation that could destroy its continuity.
Call us at 208.557.8705 and chart the course to carry out your vision and protect you in face of a worst-case scenario.