Business partnerships, like marriages, can end in “divorce.” Whether you exit with an equitable share of the business and intact relationships with your partners depends on proper planning.
Suppose you and your close friend establish a niche service business as equal owners. You provide the capital to get the company off the ground, while your partner manages the day-to-day operations and provides the consulting services. The company operates at a loss during the first few years, requiring you to inject additional capital to keep it afloat. You and your partner agree orally that the additional cash infusions are loans, which are to be repaid before distributing any profits once the business is in the black.
The following year, the company becomes profitable, but your partner wants the company to begin distributing profits to him, in addition to the sizable salary he has been receiving, before repaying your cash advances. You and your partner are at an impasse, which begins to disrupt the business. You decide that you want out, but you and your partner cannot agree on a fair price for your stake in the company. The partnership agreement is silent with regard to an owner withdrawing from the business, so you both hire attorneys. After months of quarreling and thousands of dollars in legal fees, you negotiate the sale of your interest to your partner. When the dust settles, the business has been damaged by the infighting, and your friendship with your former partner is history.
Unfortunately, we have seen just this scenario happen in real life. Going into business with others is not to be taken lightly, especially if your potential partners are friends or family members. Because of personal relationships, people tend to forego certain formalities, such as planning for the eventual exit of one or more partners, in order to kick-start the business. Yet the best time to plan for possible negative outcomes is before the partnership is consummated, so you should include an exit strategy in the shareholder or partnership agreement. If you are already in business and the existing agreement does not include a withdrawal mechanism, you and your partners should hire a competent attorney to draft one while everyone still gets along.
Even if the partnership is a success, there are many reasons to have an exit strategy in any partnership agreement. What if your business partner dies or becomes incapacitated? Or gets divorced and is required to give her ex-husband an ownership interest in the business? Or wants to sell her share of the business to a third party? Or declares bankruptcy and has to relinquish her share of the business to creditors? Any of these events could derail a thriving business and jeopardize the value of your stake in the company.
Many closely held businesses use a buy-sell agreement to provide an effective exit process. Like a prenuptial agreement, the buy-sell agreement protects the financial interests of all parties when someone wants to leave the business relationship. A buy-sell agreement usually spells out when an owner is allowed to sell his or her interest, who is allowed to purchase that interest, and how to determine the price that will be paid.
A well-drafted buy-sell agreement can provide these benefits:
- Control. The company, the remaining partners or both are often granted the right of first refusal to purchase the departing owner’s interest. This reduces the likelihood of the remaining owners becoming business partners with a stranger or an otherwise undesirable third party.
- Liquidity. The withdrawing business partner has a clear means of converting his or her ownership interest into cash.
- Valuation. As in the case I described at the beginning of this article, determining the value of a seller’s interest in the business often is a major source of controversy. A good buy-sell agreement provides a formula (such as a multiple of sales or cash flow) or a mechanism (such as an appraisal) to determine an appropriate price for the seller’s interest. The agreement also should provide for arbitration or some other method short of litigation to resolve any disagreements.
- Preservation of advantageous tax treatment. An S corporation is referred to as a “flow-through” entity for tax purposes because business profits are taxed solely at the shareholder level, unlike with C corporations (e.g., publicly traded companies), for which profits are taxed at both the corporate and shareholder levels. To maintain the more favorable tax structure, the Internal Revenue Service is selective about who can be a shareholder of an S corporation. A buy-sell agreement can include provisions restricting a departing shareholder from transferring his or her shares to a person or entity that is not a permissible S corporation shareholder.
Don’t forget that the buy-sell agreement needs to be funded in order to work. The agreement may provide for the company or the remaining owners to buy out a departing investor, but the prospective buyers must have access to cash or financing. Otherwise, the seller typically is free to sell to an outsider, which may defeat the purpose of the agreement.
The buy-sell agreement frequently will require the individual partners to take out life and disability insurance on one another, or the company may be required to purchase insurance on each owner, in case someone has to withdraw as a result of death or injury. For a voluntary withdrawal, such as when an owner decides to retire, the agreement often allows the remaining partners or the company to purchase the interest in installments over a specified period of time, such as five or 10 years.
The three main types of buy-sell agreements are cross-purchase, redemption and hybrid.
With a cross-purchase agreement, the other owners will acquire the stock or interest of the departing owner. From an income tax perspective, this is most advantageous to the remaining owners. By purchasing additional ownership units, their cost basis in the company increases, resulting in less capital gain realized upon a subsequent sale of the business.
To deal with a premature death of a partner, a cross-purchase agreement typically requires each owner to take out insurance on the lives of the other co-owners. If there are a large number of partners, such a program can be rather expensive and difficult to administer. Therefore, this method is best for a company with only a few owners. Further, at the death or withdrawal of an owner, the policies held by that individual must be assigned to the remaining partners. If not handled properly, these policy transfers can result in the unintended taxation of the insurance proceeds under the tax code’s “transfer for value” rule, leaving less money available to acquire the departing owner’s interest.
Under a redemption (or entity purchase) agreement, the company will acquire the interest of the exiting partner. It is easier and less expensive to use life insurance to fund a redemption plan, because only a single policy, owned by the company, is needed on the life of each owner. A policy on the life of a partner who retires or sells his interest prior to death can be transferred to the withdrawing owner without triggering the transfer-for-value rule. Redemption agreements are often used in companies with three or more owners because of this ease of administration. The downside, however, is that the remaining owners will likely realize larger capital gains (and therefore will pay higher taxes) upon the subsequent sale of the business than they would with a cross-purchase agreement. This is because the business generally cancels the interest it acquires from the departing owner, increasing the value of the remaining owners’ interests proportionately without increasing any owner’s cost basis. Also, if the company is a corporation, the collection of the insurance proceeds could result in the issuing of dividends to remaining shareholders, which would be taxed as ordinary income after 2010, assuming special treatment for "qualified dividends" expires this year as scheduled under current law.
The most flexible option is the hybrid agreement, because the owners agree to sell their interests either to the other owners or to the company itself. Under this method, the buy-sell agreement will give the other owners the first option to purchase the interest, and if they refuse, the business will have the second option. This structure allows the remaining owners to wait until a withdrawal is proposed to determine how to proceed.
The Makings Of A Successful Partnership
Couples that are getting married do not intend to divorce, and partners who are starting a business do not intend to soon split up. But things do not always work out as planned. To give your partnership the best chance of succeeding, follow these steps:
- Make sure you know your potential business partners well before tying the knot. Communication between you and your soon-to-be partners is essential, not only when you are in business together but also during the planning stages. Each person should discuss his or her expectations for the business, as well as the roles and responsibilities of each owner. If your goals and expectations are not aligned, this is a clear sign that the partnership is not meant to be. This exercise will save everyone a great deal of time, effort and money, whether or not you decide to move forward.
- Document everything. When decisions about the business are not in writing, too much is open for debate once an issue arises. The shareholder or partnership agreement should clearly state when profits are to be distributed and how conflicts are to be resolved.
- Hire a good attorney. Do not try to cut costs by drafting the shareholder/ partnership agreement, buy-sell agreement or loan documents yourself. This will only cost you and your partners more in the long run. Hire a business attorney with experience drafting such agreements. In some situations, especially when partners are at different stages of their careers or have different roles in the business, it is wise for each party to be represented by his or her own counsel.
- Understand that business can end the best of friendships. Even if all of your agreements are well-drafted, there is one thing they cannot account for — the emotional aspect of a breakup. You and your soon-to-be partners should discuss the possibility that the friendship may not survive the business venture. Make sure this risk is worth taking.
- Have an exit strategy. All good things eventually end.
The exits in a building are clearly marked so that people can safely find their way out. Planning for the eventual exit from a business partnership should be no different. If it is handled properly, anyone who wishes to leave is likely to do so with a fair price for his or her interest, without disrupting the business or damaging his or her relationship with the remaining partners.