Finding someone to start a business with can be an exciting time. You have 2 or more people coming together with a mutual goal in mind who are excited to move forward with an opportunity for both. In the midst of this excitement, it’s good to stomp the brakes a little and think through what’s going to be best for you and the business in the long run, such as what happens when those people that came together don’t see eye to eye anymore. Although the cost of mental and emotional energy spent in the business appear to cost much more than the cost of exiting the business, the real cost of exiting the business will be determined by the planning and attention devoted to your exit strategy, both at the beginning stages of the business and if your business relationship with another business owner goes south. In this article, we hope to shed light on options available to owners who are just starting their business and are looking to protect their business from a potential breakdown between the owners.
For better or for worse, your business entity’s governing documents are your primary roadmap to exiting a business. The most important of these governing documents is generally the operating agreement for a limited liability company, the partnership agreement for a limited partnership or general partnership, and the bylaws and shareholder agreement for a corporation. Courts generally do not like to, or are restricted by law from, imposing what they think the rules of your business should be when there are already documents that spell out the intent of the owners. This makes the terms of these documents extremely important because if these documents are silent as to a situation, a court will apply the default rules.
Your governing documents should ideally spell out the avenues you have for exiting a business. These range from the straightforward ability to transfer interests, a simple or complex buy-out provision, removal or resignation provisions and other unique provisions drafted per the specific details of the business. Your business’ governing documents are your first stop if you want to protect you interest in your business, exit your business, cause the exit of another owner or protect your business overall if your relationship with another business owner or owners goes sour.
Creating an Exit or Exiting Through the Map
At the end of the day, it is preferable to have a map that allows you to exit in a way that is fair for you. However, relationships, responsibilities and services and money provided by each of the owners in a business often govern who these provisions ultimately favor. The most common exit provisions in these documents are traditional ownership transfer provisions, buy-out provisions, and removal or resignation provisions.
A business agreement may allow owners to transfer their ownership interests to other owners or third parties. This is generally the simplest of the provisions that will be mentioned in this article, although governing laws such as federal and state securities laws will need to be considered when these provisions are drafted. The basic transfer provision usually requires the approval of all or a percentage of the management and owners of the business. The transfer also generally is required to comply with all applicable laws and the business’ governing documents. Finally, these transfer provisions also may allow an ownership transfer to an immediate family member, such as a spouse or a trust owned by the children or spouse of a transferring owner, without requiring approval, or this restrict this type of transfer could even be restricted completely.
A business’ governing documents may include a buy-out provision. Buy-out provisions can be very simple or very complex. This type of provision can be used for a variety of purposes, but is primarily used to restrict the automatic transfer of a deceased or bankrupt owner’s interest to a spouse, child or creditor and make sure that an original owner has the first opportunity to buy a leaving owner’s interest. The provision can grant the other non-transferring owners a right of first refusal if another owner decides to sell its ownership interest or force a buy-out at death or bankruptcy of one of the owners. The right of first refusal often states that the owner that’s leaving has to first offer, generally at a set or fair market value price, its interest to the owners staying in the business. A forced buy-out upon the death or bankruptcy of an owner generally allows for a nominal fee to be paid to buy-out the person to whom an interest has transferred upon the death or bankruptcy of an owner. This strategy is particularly appealing to owners seeking to continue using the business entity, even if the business plan and purpose change. On the downside, exercising this exit strategy often requires a significant amount of capital, an appraisal of the value of the business and convincing the other business owners that the offer to purchase is fair to them too.
A business can also simply allow for a vote to remove and resignation of owners as management and owners. Although provisions allowing for the removal and resignation of management upon a vote of the owners is pretty common, a provision providing for the removal of an owner upon a vote is not. These types of provisions can be structured in a variety of different ways and are often either form provisions or are based on the specifics of the transaction. Management removal and resignation provisions may require such things as good cause and lender approval. Removal of an owner is uncommon and is usually unique to the specific transaction. This would generally be someone who didn’t contribute money to the business but provides services in a different capacity, such as a developer or property manager.
The process of preparing for a breakup among the owners can be really an uncomfortable subject, but it is a necessary one if you want to protect your business down the road. Also keep in mind that each of these provisions may be modified by the owners (and their legal counsel) through drafting an amendment. Although some general examples and information have been provided here, there are limitless possibilities in drafting terms that can be included in a business’ governing documents to effectuate the exit of a business owner. Please contact our professionals at Dodson Legal Group toll free at 844-4DODSON if you are looking for more information to protect your business from the harmful effects of a potential breakup.