Setting up a new business venture can be an exhilarating and exciting time. Usually two or three entrepreneurs have a vision they want to pursue and have already determined how they’re going to get started and run the operations. All they want is for me to make it legal, fill in a few details and keep it simple. What they have not thought about is the buzz kill discussion of what happens at the end of the day. Yes, it’s easy to discuss the “we’re going to sell and make lots of money” scenario, but even that decision can be hard to make. When is the right time, what’s the right price and who makes the decision? While these discussions are hard and raise questions contrary to the entrepreneurial high of starting a new business, I recommend they be had up front, while everyone is still talking. Otherwise, they’ll be had when no one is talking or, worse yet, the decisions will be made by a judge with little knowledge of your business or industry.
Because of its governance flexibility, the most common business structure is the limited liability company, but the principles are the same for corporations. Exit provisions are typically embedded in the operating agreement of a limited liability company and the shareholder agreement for corporations. Clients may resist implementing exit and termination provisions in their agreements for a variety of reasons. They fear such deal terms make it too easy to abandon the joint venture, they can be manipulated to take advantage of weaknesses (such as access to capital) and they are unlikely to be used. I always hope the last reason is true–the best business partners work out their differences in the way best suited for their specific situation. Unfortunately, the best doesn’t always happen and that’s when the parties turn to their written agreements and hope to find a solution.
Deadlock is the most common reason for wanting an exit strategy but I rarely see it as the reason for dissolution. Typically, if a decision is so important that parties deadlock over it, it’s important enough for further consideration and an analysis of the alternatives. Simple economics usually force the parties to find a way forward. More often it’s the realities of life that cause a dissolution in small businesses. One party wants to move to a new state or pursue new opportunities, the hard work everyone promised at the beginning isn’t happening any more, or the entrepreneurial high has waned and spending most of the day with your business partner is no longer bearable.
Admittedly, rather than end the business, a lot of clients can benefit from a good business coach, mediator or counselor. As I said, the best solutions are those specifically tailored to the individuals and often the individuals are in the best position to make those decision but when they can’t or won’t, ideally there will be some solution in the parties’ agreement.
The most common exit strategy is the buy-sell provision, giving one party the ability to buy the interest of the other if certain triggers occur. What triggers the buy-sell provision often dictates the terms of a buy-sell. For example, a breach of the operating agreement or a breach of a fiduciary duty owed may result in a discounted purchase price while other triggers may result in a transfer at market value. But wanting to move out of state, the failure to be the rainmaker everyone thought the other would be or simply not getting along are likely not defaults under the governing documents or triggers to the buy-sell. To address those situations, the buy-sell might contain a put option, whereby one party’s offer to sell is also an offer to buy at the same price. The offering party may end up selling, giving her the freedom to move out of state, or may end up buying and owning the entire business which she can then sell or take with her. Yes, the put option can be subject to abuse as discussed above, but it is also an effective tool. Furthermore, the mere ability to force a sale can often facilitate a mutually agreed upon solution to the challenges faced.
Another exit strategy is establishing a fixed termination date. Pre-1996, limited liability companies wishing to avoid double taxation, once at the entity level and again at the owner level, included a fixed termination date. Once the IRS regulations changed, the fixed termination date went out of vogue, but its inclusion often fits with the goals and objectives of today’s entrepreneur. As a practical matter, it’s simple adopt. In the company charter or governing document, you simply state the company will terminate in 10 years or on some fixed date. If all is going well, the parties agree to extend the date, but that conversation will likely trigger a discussion of how the end will come. Beneficially, that discussion comes at a time when the parties know their business a lot better than they did at the beginning and can result in a more informed exit strategy. If all is not going so well, the termination date creates the opportunity to sell the business, a sale that may be to one of the existing parties or affiliated group, or simply a splitting of the assets and the opportunity to pursue a solo career. Like the buy-sell provisions, a fixed termination date is not perfect, but it’s worth considering in the right circumstances.
In addition to the buy-sell and the fixed termination date, there are many other alternatives, including variations on the buy-sell and fixed termination date provisions themselves. Because they’re trying to dictate business terms into the future, they’re naturally at risk of being wrong, abused or unhelpful. But the alternative, to have no plan, can be worse. As hard as it may be to admit your entrepreneurial vision may someday come to an end, having the discussion up front and coming up with a plan while everyone is talking is usually far better to having no plan and turning to the courts for a solution.
For more information, please contact our Business Group or call 208.344.6000.