Excerpted from Forming a Partnership (Entrepreneur Press)
At the beginning of any business partnership, the partners usually envision a long-term relationship; otherwise, they wouldn't be so willing to invest their time to share anticipated benefits with someone else. Unfortunately, expectations notwithstanding, longevity is often limited; the goals and expectations of the individual partners will change at least to some degree over a period of time. This is why an exit strategy must be developed by and between all partners. It will ensure that if one partner leaves the company, his or her absence will not destroy the integrity of the company and its ability to stay afloat.
Many Reasons to Revisit the Original Partnership Concept
There are many ways to redesign a partnership, and there are many reasons to do so. Although many times the reason is that the partners have a substantial disagreement about a material aspect of the business, this is not always the case. Over time, the goals and expectations of people are bound to change. Raising a family mandates an entirely different approach to business than when one is single. Time must be divided to achieve success in both your personal and your business life. This is not easy to do and, in many cases, the family's principal earner is forced to limit time at the business in order to succeed at home. If the reverse happens-time is curtailed at home in order to succeed in business-the result can be devastating to the family. Don't think that this is an easy decision. Thousands of real-life stories speak to the contrary. When this dichotomy becomes the principal problem, the partnership becomes both the problem and the solution. In some cases, arrangements can be made for substituting people, or reducing salaries. In other cases, the problem is not resolvable and the partnership needs to consider more drastic steps.
Anticipating the Problem
The main idea is to anticipate what problems may arise in any of the relationships [an entrepreneur is involved in] and to be prepared before the problem arises. The biggest challenges are the ones that are closest to home . . . problems within the working partnership itself. The partnership agreement is based on each partner having the responsibility for job performance, whatever it may entail. When one partner is absent, those responsibilities fall on the shoulders of the remaining partner or partners. When one partner dies, the resulting problems can be devastating to the business. This is why partnerships should carry key man insurance. The purpose of this insurance is to ensure the continuity of the business and to prevent the remaining partners from inheriting a spouse or other beneficiary of the deceased partner through a will or intestate succession.
In the event that a partner wants to leave the partnership, there are a number of approaches that can be used. One of these is for the exiting partner to have his or her equity position acquired by the other partner or partners. The one aspect of this buyout that should be sacrosanct is the continuity of the business. Very much like protecting a child of divorce, the business must be the highest priority. Although there are many more subtle considerations in the exiting of a partner, the payout of money is usually the prime element. If the company is making money, the buyout of a minor percentage of equity is no problem. If, on the other hand, the company is still in its growth period and money is tight, careful consideration must be given to the method by which the payout is scheduled. In some cases, the company itself will buy the equity position of the exiting partner and retire the shares. This will increase the value of the existing shares and all remaining partners will find that their equity positions are greater as a result. In some cases, one or more of the partners may buy the exiting partner's interest, in which case only their individual equity positions will be enhanced. In small enterprises, where there are only two partners, for example, the problem may be that neither the company nor the remaining partner is in a position to make the buyout.
Right of First Refusal
Although key man insurance may prevent the remaining partners from "inheriting" a new partner at the death of a partner, a "living, exiting partner" usually has the right to sell his or her shares in the business to a third party not already in the partnership mix. This right, however, is usually coupled with some protection for the remaining partners. In a typical partnership arrangement, all partners are given a "right of first refusal" in the event that any partner chooses to sell his or her interest to a third party. This means that if the exiting partner chooses to sell his or her shares to a third party, each of the remaining partners has the opportunity to accept this offer, thus preventing a stranger from joining the partnership.
Note, however, that the acceptance must be exactly the same as the original offer. If it is different in any substantial way, the right of first refusal doesn't apply. If a remaining partner fails to exercise this right within the appropriate time frame, then the third party may buy the interest. In a larger partnership, where this equity position constitutes a minor percentage of the company, it is less important. In a smaller partnership, where the equity position might be half of the equity in the company or a large enough percentage, coupled with others, to control the company, these elements are particularly important.
The Question of Money
It is unusual for any exiting partner to get a return of his or her investment completely at the time of the exit. This should always be addressed at the beginning of the partnership to avoid the possibility of disturbing or destroying the integrity of the company. This can happen when the payout dollars deplete the cash reservoir of the company, impairing its ability to function. In some cases, in fact, the result of not preparing for such a situation early on can cause the business to be sold in the event of a partnership breakup. Although the remaining partner or partners may be able to remain with the company as part of the transaction, this was not likely envisioned by any partner at the outset of the original partnership relationship.
Is There a Way to Do This?
Keep in mind that an exiting partner might not be leaving because the business is unsuccessful. There are many reasons for a partner to leave that may have nothing to do with the success or lack of success of the business. If the business is in financial trouble, all of the above scenarios may be applicable. If the business is successful and/or is showing great potential for the future, there are other ways for a remaining partner to handle the situation. If the partners had foresight at the beginning of the partnership, they probably agreed to have the business valued at various stages of its growth, normally once a year. By doing this, the value of the business is never in contest and the amount of any payout is determined objectively. The agreement would then go on to discuss the ability of the business to pay certain sums at certain times. With an appropriate down payment and the balance of the payout drawn over a designated period of time, the problems of payout and protecting the integrity of the company become much less problematic.
A Legal Approach
In order to prepare for the possibility of partnership dissolution or the exiting of one or more partners, the partners, by being signatories to the partnership agreement, agree as follows:
1. They shall have prepared each year, within 90 days of the close of the year, a valuation done by a person or firm designated by the parties. Should the parties fail to agree on a specific person or firm, then each partner will submit the name of a person or firm and these persons or firms shall agree on a third person or firm. If two of the three persons or firms designate a valuation within 10 percent of the other, then the average of these two valuations shall be accepted by the parties. If there is no such percentage available, then the average of the three valuations shall prevail as the value of the business at that time.
2. The parties shall use these same people or firms to determine the amount of the payout, both down payment and incremental payments for the balance of the payout, that will allow the business to maintain its continuity in the face of these payments. They will consider, among other things, the cash reservoir necessary to maintain purchase of inventory or component parts necessary to produce inventory, the personnel necessary to maintain at least the current sales position, maintenance of all equipment necessary for adequate production, and all other elements necessary and appropriate to maintaining the business.
3. The parties shall also prevail on these same people or firms to suggest methods by which the payout might be adjusted, upward or downward, based on the success of the business and its ability to pay either more or less during the incremental payback of the balance of the payout.
The above represents one approach to the question of "paying out the agreed value of the percentage being purchased" and "allowing the company to survive during this critical period." The absence of a partner, for example, might entail hiring another person to take his or her place on the business team. Contingencies of this nature must also be "plugged in" for the protection of the company. There are many other ways to create these protections. Be sure to see your professional before deciding on the language to be used.
Another Approach to Take
In the event that the remaining partner or partners doesn't have the available capital to accommodate the exit strategy, or the parties choose not to sell the business, there are yet other ways to approach the problem. Using the valuation of the business as a predicate, the remaining partners might consider the possibility of restructuring the business by inviting a new participant into the business as an investor.
In order to interest an investor, the package will usually include the following:
1. A business plan explaining the growth potential of the business and the exit strategy contemplated for any investor.
2. A combination of debt and equity (part loan and part investment) in the business. This means that part of the dollars will be repaid with interest over a given period of time, and the balance will buy an equity interest in the business, allowing that portion of the investment, optimistically, to energize the business and return a multiple of that investment over a given period of time.
3. It will be agreed that a certain portion of this package will be used to buy out the exiting partner and another portion of this package will be used to enhance the growth potential of the business.
4. The money will be used by management without the advice and consent of the investor providing only that the company achieves certain plateaus of success within certain time frames. To monitor this success, the investor shall be entitled to serve on the company's board of directors.
Again, there are many ways to design this kind of restructuring. You must consider that most private-equity firms that might be interested in such an opportunity are also interested in the exit strategy. Their attitude is that they expect a return of 20 times their investment within a three- to seven-year period. Their expectations will usually be recognized by virtue of a sale of the business. This is one of the reasons why such a strategy is more of a stopgap solution. For those entrepreneurs who want to retain their business over the long term, be careful. Be sure to speak with your professionals before embracing this kind of solution.
Protecting Against Dissolution
Keep in mind that a formal legal partnership can be automatically dissolved with the exit of one partner. For this reason, partners will invariably convert their partnership to a written agreement to a corporate entity or an LLC early on. The corporation or the LLC will maintain its continuity in the face of any exiting partner or partners.
What Makes a Partnership Fair?
When you take your company into a joint venture with another company, each business makes an initial assessment of the value of the synergy involved. It is rare that both parties bring an equal value to the table. It is even rarer to have that value remain equal after the initial phase of the relationship. Why should a partnership between two people be any different? If it isn't different, then how do the parties work out a program that makes each feel comfortable in the short term as well as in the long term relative to partnership responsibilities?
Diversity of Expectations
In many cases, the entrepreneur needs a partner with money and an investor needs a partner with creativity or experience. The problem often stems from the fact that both parties consider themselves creative. It is the objective understanding of the reality that allows two or more people to establish a teamwork environment that will help a business to prosper. In many cases, one partner has a diversity of interests and the other partner is totally obsessed by the business at hand. In other cases, one partner may want a more laid-back quality of life with family, friends, and the tennis court. The other partner may feel, and not inappropriately so, that the investment of time must be dynamic on the part of all parties until the business reaches the stage where free time may be enjoyed. One of the problems in business is that some partners never feel that the business has reached this plateau.
Return of the Dollar
Although it is normal for an investor to take "stock for money," with his or her return based exclusively on the success of the company, this is not the only way to address a partnership where one of the people involved delivers the bulk of the working capital. Even though one partner may have the expertise, the one with the money may deserve to see a return of the investment before there is an equal distribution of salary or dividend. In a lot of ways, this approach eliminates a good deal of the pressure between partners. It is appropriate to remember that, creativity notwithstanding, the business would never have left the ground were it not for the investment capital involved in the early stages of development. This is good enough reason for the investing partner to see a return of his or her investment before both partners can begin to enjoy the return on the investment.
Divorce in a Partnership
There is a business axiom that says: "Diamonds are forever; partnerships are not." Although not necessarily inevitable, it is understandable that most partnerships will be limited in time. As a result, it is always a good idea, while the parties are in good spirits, to make arrangements appropriate to each of the parties as well as to the business itself. It is not unusual for one partner or another to feel that he or she is contributing more, or participating more, and deserves more of the partnership profit. For this and other good reasons, there should be an opportunity for each to buy out the other based on a valuation formula agreed to at the beginning of the relationship. The written exit strategy is not unlike a prenuptial agreement.
The Ultimate Revisiting
At this time, there is a revisiting of the arrangement that created the original partnership arrangement-sometimes by both parties, but usually by one. It's great to have a format that will allow this problem to be resolved in a simple way. Unfortunately, time has a way of changing attitudes. And sometimes, animosity flares if the parties fail to communicate properly when the problem begins to show itself. Therefore, there should always be a mediation or arbitration clause that will allow a third party to intervene to the extent that some objectivity can be brought to bear in a situation that might otherwise be unsolvable. Be sure to include those provisions that will prevent the business from falling victim to two personalities that can't resolve their disputes. See your professional before this becomes a problem. Without the appropriate safeguards, the business itself will bear the brunt of the problem. This is not what anyone expects at the beginning of the relationship, nor is it what either party deserves as the relationship comes to an end.