One of the most common challenges with startups and closely controlled companies is what happens when someone wants out of the arrangement or there is a disagreement between the owners about how the company is run.
Maybe one of the owners is spending too much money on fancy dinners, not putting in enough hours, or generally not holding up their end of the bargain. Or, what if one of the owners has a drastic change in circumstances and wants to exit the enterprise unexpectedly and immediately?
Before we start, some basic language. There are a number of different entity types that can include multiple owners - these can include partnerships and corporations (like limited liability corporations (LLCs) and traditional “C” corporations). The terminology for each is different: in partnerships, the owners are called “partners” and they typically are governed by a partnership agreement. In corporations, the owners are called “members” and are governed by an operating agreement. For today, we are going to refer to both partners and members as “owners” and use the word “agreement” for both partnership and operating agreements since they serve much of the same purpose.
When starting a business, how much do you want to define up front?
Starting a business with another person is sort of like meeting a “special someone” and falling in love.
Everything they do is magic.
You can never imagine not wanting to see or talk to them.
And you seem to agree on everything, probably even finishing each other’s sentences.
For many people starting a business, they are not thinking about the issues they might have down the road, or how they will handle disagreements or exits. However, the choices you make when starting a business are much like the ones you make before getting married: do I shove my head in the sand about the issues that might affect us later (are we having kids? how will we spend and save?) or do we discuss these issues and even potentially include them in a partnership or membership agreement (which operates like a prenuptial agreement for business).
My advice: make sure you are on the same page before getting “married.” See below for a PrepOverCoffee toolkit with specific questions to aid in the upfront planning process.
Normal operations and return of capital
Partnerships and corporations are created for moving the business forward. If there is no finite time of operation, it is assumed that the parties intend for them to continue operations indefinitely. Then, once a business starts to make money, it is assumed that capital contributions will start to be returned to the owners, and once those initial investments are returned, then distributions of profits can begin to be paid based on ownership percentages (or distribution percentages if those are specified).
The breakup
But, what happens to normal operations when one owner decides, possibly unexpectedly, to leave the business? And worse, when that owner demands their capital investment back right away so that they can use it in some other way. What do you do?
Do the remaining owners have to give the exiting owner their initial and subsequent capital investments back?
Owners of a company (partnership, LLC or otherwise) are still a lot like shareholders in a public company. They “invest” in the entity and that capital is utilized for the benefit of the company.
There is also a risk of loss that comes with most investments. Unless expressly required under the entity’s governing agreement (which may be verbal in some instances) or state law where the business is incorporated (which changes frequently and cannot always be relied upon), the exiting owner is not entitled to get their invested capital back. Said another way, if you buy stock of the XYZ Company on the open market for $10/share. A year later, XYZ Company has lost the majority of its value at the share price is now $1/share, you do not get your $10/share back.
The same goes for a privately owned entity.
State law generally uses some form of the fair market value of the business to determine the value that is to be returned to the exiting owner, if any
If one owner wants to exit the business and the agreement is silent as to how that exit works, the owners turn to state law to “fill in the blanks” mainly because (1) capital investments aren’t typically sitting untouched in a passbook savings account waiting to be returned, and (2) the other owners have relied on the availability of those contributions to support the business and have made decisions accordingly.
Under state law, most entities are required to calculate a fair market value of the company, which includes understanding current and expected sales, as well as current assets reduced by liabilities or debt. Then, based on that valuation, each share of ownership is valued and the exiting owner receives the “share price” for their shares that they then transfer or sell to the remaining owner/s. But this only works if there is a value to the business.
Fair Market Value = $0 (Aka my business is worth nothing on paper)
In the early years of many businesses, the business itself is worthless (on paper). There might not be enough sales to support the operation, or the liabilities stemming from startup costs and other debt might dramatically exceed the assets. In these instances, the remaining owners do not necessarily owe the exiting owner anything and certainly will not be required to go into debt or raid their own personal savings to refund the exiting owner’s capital contribution at 100%. (Note: If that were the case, we could all sell our shares of WeWork for the 2021 initial public offering price instead of the 48 cents per share it is worth today.)1
How does it usually work at new companies? For better or worse….
For our purposes, let’s assume you are like most2 of the business owners out there:
you pulled an agreement that you barely understood off the internet; and
the agreement included only the bare minimum provisions, and nothing about deadlocks, ongoing issues, exits, etc.; and
all of the owners’ investment capital went to buying supplies, goods, establishing the business; and
the business bank account is hovering at zero, and there are no current sales or business prospects in the pipeline that will dramatically change the financial position.
At that point, and based on these assumptions, you have three key choices:
BEHIND DOOR #1: The promissory note.
In this option, an agreement is drafted that transfers shares from the exiting owner to the remaining owner/s so that the remaining owners own 100% of the enterprise and can make all decisions (as well as readily seek additional financing or investors, who would otherwise avoid a situation where there is a current “owner dispute”). In exchange for “selling” their shares, the exiting owner’s “interest” in the company is converted into a promissory note. The note may be payable at sale, when new financing or investment is received, if the company is acquired or merges with another entity, or when the company makes more than a certain threshold gross revenue. The promissory note makes the exiting owner an unsecured creditor in the business.
This solution is helpful for a friendly breakup and allows the exiting owner to potentially get some of their investment back in the future and recoup some of the rewards of being an initial owner. However, the amount of the promissory note likely will not be for the full value of the exiting owners investment, as the other owners need to consider their additional labor during the life of the promissory note where the now exited owner isn’t doing anything to move the business forward, the additional investments the remaining owners may need to make, and the impact of returning capital on the timing of potential distributions, etc.
BEHIND DOOR #2: Wind up the business and go dance on your own.
Wind the business up completely. Sell the assets that can be sold. Pay all of the debts. Take the remaining value, if any, and distribute it between all the owners based on their ownership percentages. Everyone rides off into the sunset, likely with a lot less money than when they started the business since the business did not have a fair market value to begin with. The downside of this solution is that the owners have no opportunity to achieve the value on their investment, which was for a much shorter time than the owners anticipated when they made their initial investments.
BEHIND DOOR #3: Mediate, arbitrate or go to court.
The final option if the parties cannot come to an agreement is to pursue some form of third party dispute resolution, either through mediation, arbitration, or litigation. For more on mediation and arbitration, check out “We Can Work It Out” from the PrepOver Coffee archives. Generally speaking, courts will generally not require the return of the capital contribution if there is no fair market value to support the return of that contribution. The remaining owners will likely want to avoid the expense and distraction of litigation but may have no choice if the exiting owner does not accept that they will not get their capital contributions back, or if there is a dispute about the value of the entity. The “exiting” owner is still an owner (albeit a very unhappy one), and the business will have to continue to try to operate while the trial process continues at a glacier pace, with every remaining owner feeling the hurt.
And remember above where lenders and investors won’t touch businesses where owners are in dispute? Imagine how they will react if the owners are in the middle of a protracted litigation.
There is a way to avoid the hurt.
Upfront planning can save a lot of time and heartache when starting a business with another person.
This example above is extreme but still common. The good news is that it can be avoided with just a little upfront planning and an agreement prepared specifically for your entity.
Since 11 is my favorite number, below are the top 11 early decisions and planning questions that can alleviate many of the downstream issues of owning a company with other people.
And as you can imagine, many of these areas are much easier to decide when everyone is friendly instead of later, when no one gets along.
PrepOverCoffee Toolkit for Starting a Business: Considerations for your partnership/operating agreement
What entity type is best for your business? This is often a complicated question involving your exposure to liability, your plans for raising funds, and your accounting and tax plans.
Will all owners be “equal”? Contrary to the opinions of some, there is no requirement that all owners must have equal ownership, and in fact, few do. There is sometimes an equity owner who contributes more capital but does less work, and a “labor” owner, who contributes less capital but does more work. Their ownership percentages, distribution percentages, and voting rights may differ because of these things.
What are the responsibilities of each owner (who is the CEO or manager of the enterprise, who coordinates the vendor arrangements and decides on the creation of payment obligations, who provides day-to-day efforts in support of the business, who is on the Board, etc.)?
How is each owner paid? Will there be salaries or will the only money leaving the business be in the form of profit distributions? How will the owners determine when the business can afford to pay salaries? How will the owners fund their own individual lifestyles in the event there is no salary for a period of time?
What happens if there is a deadlock regarding a major decision?
What happens if one partner/member does not like how the other partners/members are doing something or meeting their responsibilities? What options do they have?
What happens if one partner/member wants to sell their ownership interest to a third party?
What happens if a majority of owners want another owner to exit?
Can additional owners join later? How will they be selected?
How would an exit of a single partner or owner affect the business and how would that exit work? Can they compete with the business?
Who owns the assets and intellectual property in the event the parties wind down the entity?
ESPRESSO SHOTS:
The semester end is now here and I’ve been focused on TV to distract myself from missing the “kids.” (If this reference makes no sense, check out last week’s Teaching as a Petri dish for effective leadership.)
If you weren’t already one of the people that made the show #1 on Netflix within 24 hours of its arrival on the streaming service, check out The Diplomat. It is also proof that sometimes your hair pays the price for your difficult job, even if you once played Felicity and broke the internet when you got a haircut.
While you are there, check out Devil in Ohio (no, not my autobiography).
And finally, if you miss Captain America, check out: Ghosted on AppleTV.
This is based on my own highly unscientific experience, not some Harvard Business Review study or otherwise. And this approach is common, but not advised.