Vital Exit Strategies for Your Partnership Agreements

Posted on June 22, 2013 in Business Partners

Many people have started a business partnership (or limited liability company) with at least one other person. According to the IRS, that’s at least 14 million people. And that doesn’t include those who have started small corporations with other owners – which could easily double that figure. But according to AssociatedContent.com, up to 70% of all business partnerships do not last. That means that less than 1 in 2 business partnerships have the potential to work out for the long haul.

The numbers may be depressing, but they don’t have to paralyze you from moving forward with another business owner. A business partnership differs from a personal relationship/partnership in one important, fundamental way: It’s just business. You can prepare for a split in your business partnership with a lot less emotional upheaval than you might in a personal relationship.

This is where partnership agreements come in. Partnership agreements – whether they are (officially) shareholder agreements for a corporation or operating agreements for LLCs – give you an opportunity to decide with your business partner “what’s fair” in the event of a split before it ever happens. This is what’s commonly known as an “exit strategy.” And while exit strategies are important in all different kinds of business relationships, there are particular issues that crop up when two or more people form a business together.

Here’s what can happen if you haven’t thought through your exit strategies with your business partners:

A Cautionary Tale

Gregory (our client) and Kristov were boyhood friends in the Czech Republic. Their families emigrated to the U.S. at about the same time, and for years they wanted to start a men’s clothing line together. They formed a corporation and signed a shareholder’s agreement under which Gregory was obligated to put in the money and Kristov promised to put in the marketing and clothing design ideas.

About a year later, there came a time when Kristov was spending the money on fancy parties and supermodels faster than Gregory could make it, and Gregory wanted to call a “time out” to re-assess how the money was being spent. Kristov was incensed. After all, marketing was his job and Gregory was supposed to fund his work. Gregory was incensed. After all, money didn’t grow on trees and there had to be some fair way to stop the bleeding. Their shareholder’s agreement had no provisions on how to resolve basic disputes between the business owners and no provisions on how to handle a buyout of the company if they reached a deadlock. As a result, the company went through expensive litigation to dissolve and liquidate the business . . . which effectively destroyed the company and the friendship between the two.

Reasons for “Wanting Out” and How to Handle It

How can you avoid this disastrous result? By taking some time to think through the reasons that a business owner might want to leave the company and what would be a fair price for his/her interest in the company. There are lots of reasons that an owner might want to leave your company. And while it’s impossible to foresee each and every one of them, there are certain broad categories that tend to cover most situations. Your job, along with your prospective business owners, is to decide what you feel would be the fair way to handle each of these situations, if and when they arise.

  1. Death. Should a business owner die, you have more issues to face than simply, “how do I replace him/her so that we can avoid a financial setback?” If the right provisions aren’t made, you could also find that the deceased owner’s spouse inherits the shares and becomes your co-owner, continuing to expect the same salary and profits from the business.
  2. Divorce. Similarly, depending on the state, a divorcing business owner’s spouse might be entitled to a portion of the owner’s interest in the company. Do you want this to happen?
  3. Disability/Incompetence. Disability (physical) or incompetency (mental) of a business owner can often result in a greater financial drain than death unless the necessary provisions and disability insurance funding are put into place. How long can the business afford to pay the salary, benefits and profits of an owner who is too disabled to work or make a financial contribution to the company?
  4. Resignation. An owner may want to leave the business voluntarily. Perhaps the business is not generating enough money for them to meet their needs. Or, they are facing a lifestyle change, such as having caretaking responsibilities for a chronically ill parent or new baby. Or, perhaps they have an opportunity to fulfill a lifelong dream of working with the Peace Corps. Or, they want to retire. The partnership agreement should include a procedure for purchasing the resigning partner’s interest.
  5. Expulsion. Sometimes, you face the unpleasant situation of needing to kick out an owner involuntarily. Perhaps the owner was caught with a hand in the company till. Maybe an owner refused to contribute more money to help the company. Perhaps one of them has repeatedly been sexually harassing employees. If you reach the point where, for grave reasons (not just “we don’t get along”), you need to give an owner the boot, the agreement should spell out those situations.
  6. Disputes. This is where Gregory and Kristov went awry. Although they had an agreement covering “who would do what,” their agreement did not address what happened if they reached an impasse in how to run the company. Which, unfortunately, they did. Whether a dispute over more mundane issues or a serious deadlock over a major aspect of the business, their agreement failed to include a procedure for resolving disputes of any kind . . . which meant that their only recourse was the most drastic one: business dissolution. 
  7. Value of the company. This is one of the most important items in a partnership agreement. Just as “all roads lead to Rome,” so all roads to exit strategy and buying out an owner’s interest lead to the questions, “how much is the interest worth?” “Is that a fair price?” And “how soon do I have to pay for it?” When you include – in advance, before you need it – a procedure or means for valuing the company, all owners can rest more easily with the knowledge that they would receive an objective and fair buyout.Far from being the proverbial bucket of cold water over your business nuptials, partnership agreements are terrific ways to prepare for the worst (an owner choosing to leave the company) while you work toward the best. They provide you with the opportunity to decide “what’s fair” before there’s anything significant at stake, and to do so when the two (or more) of you are getting along well. Even better is to work with an attorney who understands small business partnership agreements to ensure that yours provides maximum coverage!

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