Often lost in the excitement and hustle of creating a new business partnership is the exit strategy. It seems that as we enter a peaking or plateau of business sales in the middle market, more and more calls are coming into our office with one common problem: partnership disputes.

Specifically, we’re going to talk here about the exit plan, or lack thereof. Owners often form partnerships without the proper organizational documents, such as a shareholder agreement or operating agreement. These are agreements that should specify, among other things, an exit plan in the event that either (i) a shareholder desires to exit the business or (ii) an involuntary event occurs, such as death or permanent disability. Well-thought-out organizational documents dictate what happens in such scenarios, eliminating or at least mitigating the chances of a dispute occurring when that scenario actually occurs. Because most state law does not place any requirements on partners in those scenarios, the absence of such organizational documents creates a vacuum in which both sides can take any position they want, no matter how irrational or unfair. The occurrence of such a dispute among owners can, and often does, spell disaster for the underlying business, thereby hurting all the owners. Moreover, if the dispute escalates into a lawsuit, each party will likely spend exponentially more money on litigators than they would have on a properly drafted shareholder agreement or operating agreement.

Despite the best of intentions, a partner could desire to exit the business for any number of reasons, such as:

1. Change of heart/new opportunity;
2. Burnt out;
3. Need for capital;
4. Health issues/age;
5. Divorce;
6. Perceived unfairness (e.g. doing more work than the other partner); and
7. Dispute over operation/direction of the business.

Friends often choose to start a business partnership due to a shared vision and compatibility. Unfortunately, all too many friendships have ended as the result of a failed business partnership. I believe this is largely avoidable with a solid operating agreement or shareholders agreement – one that specifically lays out the terms and conditions that will apply if and when a partner wants out or involuntarily exists. One could argue that this event is simply planning for the inevitable.

Complicating the partnership exit is the fact that the vast majority of private stock shares are extremely hard to sell in the open market, particularly if only a portion of the shareholders are willing to sell to a third party. This limits the exit options for all partners. Also complicating matters are the following:

1. Ascertaining the value of the business;
2. Determining how and when the buyer pays seller for their shares (g., cash, seller note, 3rd party debt, earnout); and
3. Other terms of the transaction, such as non-compete agreement, confidentiality, announcements, division of cash, closing date, and the attorney to draft buyout documents.

If there’s been one surprising finding during my career in M&A, it’s probably the percentage of partnerships that have inadequate or no partnership/shareholder agreements in place. This is one of the major destructors of value in private enterprise. I’m talking Billions on an annual basis.

Common exit methods to consider include “put/call options, “shotguns”, redemptions at predetermined valuation methodologies, registration rights, forced sales and liquidations. For example, a “shotgun” clause entails the Initiating Party setting a price to purchase the shares of the business from the other party (“Receiving Party”). The Receiving Party then must either accept the price offered and sell, or conversely, they must agree to purchase the Initiating Party’s shares for that same price. Once the offer is made, the Receiving Party is compelled to make a decision. That is a clean and simple solution. But it also favors the partner with more liquidity. As David Black, an M&A Attorney and partner at Berger Singerman notes, “[a]ll exit strategies have benefits and disadvantages. There is no one size fits all. The parties should have adequate counsel to help them understand their options and select the one that is right for them. And this is better done at the start of a partnership, as opposed to the time of exit, since it is easier at the start to have the parties looking at the options objectively rather than through the lens of what is better for them once the exit event occurs.”

Even the most profitable firms are not immune to partnership disputes and value destruction. Buyers will often avoid even discussing a sale with a firm in the throes of a partnership dispute. Our firm has turned down opportunities to represent highly profitable firms for this same reason. Often those shareholders contributing the most to their firm’s destruction are the ones who benefit the most from the status quo. These standoffs can essentially make a business unsalable altogether.

If you endeavor to form a business partnership, or if you already have one, it is absolutely essential that you formalize an exit strategy. This is much easier to do at the beginning than down the road when the business has built up value. Recognize that even if you and your partner are on the same page now, your lives, just like your business, will evolve and change. If that change results in you and your partner diverging in your goals, vision, needs, or plans, it could destroy what you have built in the absence of adequate planning and document drafting. Hire a competent M&A attorney to draft this document. Agree on the terms. Make sure all parties sign it. Then, review it yearly and make changes if needed. It will cost you a few bucks going in, but may just save you millions in the long run. And maybe even your friendship.

However, if you find yourself in the throes of a partnership dispute, there may be hope. We have experience working through disputes related to business partnerships. Drop us a message at info@sm2advisors.com to set up a time so we can discuss how SM2 can help you navigate these troubled waters.

Special credit to attorney David Black of Berger Singermann for his contribution.