The flight attendants on commercial flights notify passengers where the exits on the plane are located. Fortunately, the vast majority of air travelers never have to put this advice to use. In private companies, however, business partners head for the exits far more frequently as over the past decade, less than half of startup businesses survived longer than five years, and just one-third lasted for more than ten years.
Our previous post discussed steps business partners can take to avoid and resolve disputes. This post confronts the situation in which business partners conclude they cannot resolve their conflicts, and one or more of them decides to exit from the business. While breaking up can be hard to do, it should not threaten the company’s continued existence, particularly if the owners had previously negotiated and adopted a “corporate pre-nup” that will guide a partner’s departure from the business.
The Buy-Sell Agreement Provides a Clear Off-Ramp
The sale or other transfer of an ownership stake in a private company is far more complex than trading stock on a public exchange, which can be quickly done on any mobile device with access to the internet. A private company transfer becomes even more challenging when the sale is being triggered by sharp conflicts between the partners/owners of the business.
These business partner conflicts can be significantly reduced, however, if the owners had the foresight to include a buy-sell agreement in the company’s organizational documents or in a separate owners’ agreement. Buy-sell agreements (also known as redemption agreements) dictate the terms governing the owners’ exit from the business, including: (i) when the owner can trigger the buy-out, (ii) how the ownership interest will be valued, and the terms for payment of the owner’s interest. We reviewed a number of issues pertinent to buy-sell agreements in a previous post.
Financing/Equity Options Permit the Buy-Out To Take Place
A business partner’s desire to depart from the business may come at a difficult time for the company. Specifically, the company may lack sufficient funds to meet the departing owner’s demand for a buyout even if the payments are structured over a period of years. The company’s cash crunch, however, does not leave the owners without options to move forward with a transaction that will permit the departing owner to exit the business on schedule. There are a variety of financing or equity solutions available that can facilitate a business partner exit.
A thorough review of available financing options available to the business is beyond the scope of this post, but the non-departing owners can consider a number of options to facilitate the departure of a business partner that include all of the following:
- regular bank debt,
- mezzanine debt from an alternative lender, which typically carries higher interest rates, and may include an equity component,
- bringing in a new (and more helpful) equity partner to take over the position held by the departing owner,
- considering a capital call to remaining owners, or
- requesting the departing owner sell less than his/her full ownership stake and retain a carried interest in the business, perhaps with different terms for a future exit from the business.
A Clean (and Final) Break Best Serves All Parties
For a business partner’s departure to be successful long-term, it needs to be a clean exit that resolves all claims between the parties. Business partners should be able to part ways with certainty knowing they will not be dragged back into future business conflicts with each other. To accomplish this clean, final break, the owners need to document the exit of a partner in an agreement that includes a carefully drafted and comprehensive mutual release covering all legal liabilities, both known and unknown.
The settlement agreement will need to cover, among other things: (i) the final tax liability of the departing owner so that he is not hit with unexpected taxes in the K-1 issued the following year after the transaction takes place, (ii) there are no undisclosed payments or obligations any party has other than those expressly set forth in the agreement, (iii) the full interest in the company held by the owner and all of his affiliates is being transferred and (iv) the release granted to the departing owner is from the company, as well as from all of its owners.
A Safe Landing
Most conflicts between business partners don’t result in anyone leaving the business. In fact, creative differences between owners over the direction, vision and plans for their business can be healthy and lead to better outcomes for the company, its employees, and its clients. When these conflicts become irreconcilable disputes that lead to deadlock in the business, however, one or more of the owners may need to exit the business before it becomes too dysfunctional and adversely impacts the company’s performance. In this situation, all parties can arrange for a smooth transition if they adopted an exit strategy, which details the terms under which a partner’s exit from the business will take place.
Planning for the potential future exit from a business is the best possible way for a business owner to protect his/her long-term investment in the business. And the best time to install this corporate pre-nup is either when the owners form the company or when they make their investment in the business. At this stage, the owners will be in relative harmony, and that will allow them to negotiate and agree on an exit strategy that meets their individual business objectives.