Starting a business with one or more partners is a lot like the beginning of any relationship, all parties’ hopes are high and all either one can see is a long-lasting, picturesque bond. During the honeymoon phase the relationship flourishes and both parties are cooperative and largely unselfish. Both parties work to achieve a common goal and are more likely to listen, compromise, and forgive. As time goes on, some relationships continue down this road of bliss and development… but what happens to those relationships that become unstable and/or unworkable? What happens when one person wants to call it quits? How does one make a clean exit?
In many instances, no one considers the ending of the relationship when everything is fresh and new. Many companies fail to put the proper documents in place to control the internal business relationships. Unlike a personal relationship, exiting a business and/or dissolving that business can be extremely complex, stressful, and costly – especially if you do not have the proper legal documents in place.
As an attorney, I have seen many cases where distrust, disdain, divorce, or a general difference in vision has led to one or more partners wanting to exit the company. I have also seen instances in which the parties could not agree to disagree, so they agreed to fully dissolve their business. The only problem was, there was no clear legal documentation as to how that process was to be handled. Consequently, they were either left with a former business partner maintaining a large holding in the company, giving a larger-than-expected payout to buy back their former partner(s) shares of the company, or incurring hefty legal/litigation expenses trying to figure out how to divvy up the business assets.
So how does an entrepreneur properly strategize for success as well as secession? Start with these two words: Operating Agreements (for LLC’s), Shareholder/Buy-Sell Agreement (for Corporations). For purposes of this article we will generally call them partnership agreements.
A partnership agreement is both a contract between the business and the owners, and an agreement between each of the owners of the company. It lays out the rights and obligations each owner has to the company and to each other. More importantly, it specifies who owns what percentage of the company and, when properly drafted, what happens when an owner exits the company, gets married, or wants to assign his/her rights in the shares to a third party.
For instance, let’s say that you have a limited liability company and you put in $800 and your partner puts in $200. You two plan on splitting the company (and it’s profits/losses) 80/20 with 80% going to you, but you never activate a shareholder agreement. Now let’s say that your company grows to be worth $1 million and your partner, who was expected to only own 20%, exits the company or dies while married. In both instances there is no signed agreement stating what happens next, so state law controls. In Illinois and many other states, the exiting partner or, in the latter example, the wife of the deceased partner could lay claim to 50% of the business… and they could win!
This is a basic example but the stakes are continuously raised as your company grows and thrives. With a properly drafted partnership agreement, the company and all owners, especially the non-exiting owners, are more protected from adverse situations and costly back-end legal fees.
So start smarter and plan for the end by drafting a partnership agreement that is properly tailored to fit your business needs and expectations.