Divorcing your business partner can be very similar to divorcing a spouse – – at least in the financial sense. The former more often leads to litigation in my experience. I also see a lot of business owners who do not have formal operating agreements and/or buy sell agreements in place. Just like forming a marriage, it is easy to form a “partnership” but not at all easy to break one up.
What Can Operating Agreements Do?
Operating agreements must apply to your business circumstances and include all relevant information that makes them effective. They must be able to define ownership structure and spell out how profits are divided among those owners. A good operating agreement establishes who will manage the business, address specific decisions (i.e., compensation, transactions, incurring debt, etc.) and the manner in which those decisions will be made. Lastly operating agreements address what will happen if one owner dies or wants to sell his/her interests.
While these agreements can be oral, proving oral agreement in a court of law, while possible, can be very time-consuming and costly. Oral agreements have to rely on judgement but also records such as financial statements to understand how business was conducted under normal circumstances or “as usual” in terms of profit distribution. But it’s harder to determine “what ifs” such as death or liquidity events.
Just like in a marital divorce, business owners can take the initiative and decide how to operate the business or “split up”. The more they do this the less likely a court will have to decide thus keeping costs as low as possible. In many cases, however, emotion can take over in both “divorce” circumstances and prevent this from happening. In addition, if two 50/50 owners with equal voting rights cannot agree on how to operate the business at some point, they risk a court dissolving the business and splitting the assets without a clear operating agreement. Similarly, if a minority shareholder gets forced out, dies or voluntarily decides to leave and sell, operating agreements can prevent litigation and a judge’s interpretation of a minority share’s value.
Moreover, two or more majority shareholders forcing out a minority shareholder for lack of performance or other issue will need a good operating agreement that outlines reasons for doing this but also the value at which shares can be purchased. However, a judge could still rule, under certain instances, that a shareholder would be entitled to have their interest appraised by a “valuation expert” who subsequently testifies regarding their opinion of value. All parties can engage a valuation expert.
What About Buy Sell Agreements?
Buy sell agreements are generally made part of an operating agreement or can be a separate document. Again, without this in place owners can be subject to a costly legal battle during a life event such as divorce, retirement, or death. A buy-sell agreement specifies:
- Whether a member can sell to outside parties or only to LLC members
- What circumstances could trigger a buy-out
- What constitutes Fair Market Value
Buy sell agreements can be put in place at any time and are one of the most overlooked protection vehicles by business owners in my experience. They should and can be thought of as a prenuptial agreement for the business. It provides a legally binding exit strategy.
We are business valuation experts and can provide referral to legal counsel as needed and valuation consulting in a number of different areas like divorce, shareholder buyouts (voluntary or involuntary), exit planning, and transaction advisory.