“PARTNERS” FOREVER ?
MAYBE NOT
In some ways, going into business with someone is like marriage, at least old-fashioned marriage, where the parties, lost in a romantic haze, know that they will be happily together until the end. As we all know, it doesn’t always work out that way. In business, it’s best to be prepared from the beginning for disagreement, disenchantment, disability, or death.
CAVEAT – Individuals working together or setting up a business together often refer to each other as “partners.” Casual, informal use of this legally loaded term is OK, but unless your business is one of those extremely rare cases where a partnership is appropriate, you must avoid referring to “partners” in any legally-significant setting. A partnership is one of several types of legal entities, but unless specially qualified, a partnership does not provide limited liability protection to the partners. That’s the function of corporations and limited liability companies (LLC s). The consequences of misusing the word “partner” can be severe – a business associate who is reasonably misled into thinking that he is dealing with a partnership, and claims to have relied on the personal financial situation of the partner when entering into a contract, project or other arrangement, might convince a court to “pierce the corporate veil” and make the “partner’s” personal assets available to satisfy the company’s obligations.
It’s important for shareholders or LLC members to establish mechanisms for separating when they first start up. The most basic issue is who gets to choose – does the shareholder or member who wants to leave the company have the right to require the company, or its shareholders or members, to buy him out, or does the company have the right to require the departing holder to sell his holdings to the company or other holders? Most people’s answer to this question would depend on whether they are the one going or among those staying, but by the time that is known, it is obviously too late to agree upon an arrangement. In advance, the parties have to decide whether it is more important for the company to be able to continue business as usual, after a departure, or whether they prefer to emphasize the ability of a departing holder to take his capital with him.
Death of a holder is one reason for a departure. The shareholder or operating agreement should provide for what happens if a holder dies. Whether the company or the other holders have the right to require the deceased’s estate to sell his holdings back, or the estate has the right to require the company or other holders to buy the holdings back, the agreement will have to provide for the terms of payment (cash, promissory note, or combination). Sometimes, the company takes out an insurance policy on the life of a holder and uses the proceeds to buy out his holdings.
Disability of a holder is another reason for departure from a company where the owners are active participants. As with death, the basic questions is who gets to decide what happens, the company or the disabled holder or his representative. An additional set of concerns arises in connection with disability – how to define it in terms of severity, duration, medical condition, etc. While disability insurance may be used to fund a purchase, such insurance is substantially more expensive than life insurance and consequently used less.
Disenchantment and disagreement of one or more holders is more common than death or disability, and funding with insurance proceeds is not an option. In a company where the holders work in it, the others may agree that one holder is not pulling his weight and want to get rid of him. They would rather be able to sell his holdings to a more promising individual, or at least to stop making distributions to someone who in their view hasn’t earned them. On the other hand, a disgruntled member may well want to leave and have his holdings bought so that he can invest his funds elsewhere.
Regardless of which side initiates the buy-out, the departing holder’s holdings will have to be valued as of a certain date. How to determine the value is the most contentious aspect of any buy-out. It has been said that valuing a business is more art than science. Naturally, the company or remaining holders who are buying want a low price and the departing holder, a high one. Again, some kind of plan or formula has to be agreed on from the beginning, before anyone knows whether he will be a buyer or a seller.
Some agreements provide that the holdings be valued per unit at the company’s book value divided by the number of shares or membership units outstanding. This is probably the easiest formula for the parties to agree on a number, but it usually results in undervaluation. Some agreements provide for a multiple of earnings. Others require the holders to agree annually on a valuation which will control for the next year. The problem with this approach is that usually they fail to do so after the first year. Other agreements require engagement of an outside expert to value the company, a expensive proposition. Some agreements provide that both the company and departing holder engage valuation experts and split the difference. This is even more expensive. Often business owners when starting up don’t want to wrestle with such difficult and contentious issues, but that is precisely why they should do so.
DISCLAIMER – This article is for general information only and is not intended to provide legal advice or to address specific legal problems. This article does not create an attorney-client relationship. For legal advice concerning business arrangements and all other legal matters, consult an attorney.
Partners Forever
“PARTNERS” FOREVER ?
MAYBE NOT
In some ways, going into business with someone is like marriage, at least old-fashioned marriage, where the parties, lost in a romantic haze, know that they will be happily together until the end. As we all know, it doesn’t always work out that way. In business, it’s best to be prepared from the beginning for disagreement, disenchantment, disability, or death.
CAVEAT – Individuals working together or setting up a business together often refer to each other as “partners.” Casual, informal use of this legally loaded term is OK, but unless your business is one of those extremely rare cases where a partnership is appropriate, you must avoid referring to “partners” in any legally-significant setting. A partnership is one of several types of legal entities, but unless specially qualified, a partnership does not provide limited liability protection to the partners. That’s the function of corporations and limited liability companies (LLC s). The consequences of misusing the word “partner” can be severe – a business associate who is reasonably misled into thinking that he is dealing with a partnership, and claims to have relied on the personal financial situation of the partner when entering into a contract, project or other arrangement, might convince a court to “pierce the corporate veil” and make the “partner’s” personal assets available to satisfy the company’s obligations.
It’s important for shareholders or LLC members to establish mechanisms for separating when they first start up. The most basic issue is who gets to choose – does the shareholder or member who wants to leave the company have the right to require the company, or its shareholders or members, to buy him out, or does the company have the right to require the departing holder to sell his holdings to the company or other holders? Most people’s answer to this question would depend on whether they are the one going or among those staying, but by the time that is known, it is obviously too late to agree upon an arrangement. In advance, the parties have to decide whether it is more important for the company to be able to continue business as usual, after a departure, or whether they prefer to emphasize the ability of a departing holder to take his capital with him.
Death of a holder is one reason for a departure. The shareholder or operating agreement should provide for what happens if a holder dies. Whether the company or the other holders have the right to require the deceased’s estate to sell his holdings back, or the estate has the right to require the company or other holders to buy the holdings back, the agreement will have to provide for the terms of payment (cash, promissory note, or combination). Sometimes, the company takes out an insurance policy on the life of a holder and uses the proceeds to buy out his holdings.
Disability of a holder is another reason for departure from a company where the owners are active participants. As with death, the basic questions is who gets to decide what happens, the company or the disabled holder or his representative. An additional set of concerns arises in connection with disability – how to define it in terms of severity, duration, medical condition, etc. While disability insurance may be used to fund a purchase, such insurance is substantially more expensive than life insurance and consequently used less.
Disenchantment and disagreement of one or more holders is more common than death or disability, and funding with insurance proceeds is not an option. In a company where the holders work in it, the others may agree that one holder is not pulling his weight and want to get rid of him. They would rather be able to sell his holdings to a more promising individual, or at least to stop making distributions to someone who in their view hasn’t earned them. On the other hand, a disgruntled member may well want to leave and have his holdings bought so that he can invest his funds elsewhere.
Regardless of which side initiates the buy-out, the departing holder’s holdings will have to be valued as of a certain date. How to determine the value is the most contentious aspect of any buy-out. It has been said that valuing a business is more art than science. Naturally, the company or remaining holders who are buying want a low price and the departing holder, a high one. Again, some kind of plan or formula has to be agreed on from the beginning, before anyone knows whether he will be a buyer or a seller.
Some agreements provide that the holdings be valued per unit at the company’s book value divided by the number of shares or membership units outstanding. This is probably the easiest formula for the parties to agree on a number, but it usually results in undervaluation. Some agreements provide for a multiple of earnings. Others require the holders to agree annually on a valuation which will control for the next year. The problem with this approach is that usually they fail to do so after the first year. Other agreements require engagement of an outside expert to value the company, a expensive proposition. Some agreements provide that both the company and departing holder engage valuation experts and split the difference. This is even more expensive. Often business owners when starting up don’t want to wrestle with such difficult and contentious issues, but that is precisely why they should do so.
DISCLAIMER – This article is for general information only and is not intended to provide legal advice or to address specific legal problems. This article does not create an attorney-client relationship. For legal advice concerning business arrangements and all other legal matters, consult an attorney.