Let's Call it A Prenuptial Agreement For Your Business
by Dave Driscoll
Many businesses are created by partners. Having a partner can provide the courage to take the leap into entrepreneurship. The enthusiasm is infectious and you launch the business as quickly as possible to capitalize on opportunities. But first: Please take time to understand the unique value each party brings to the table. And document it.
Each partner brings the unique value of his/her talent and treasure. When you start the company, immediately create a buy-sell agreement recognizing each partner’s contribution as a percentage of ownership and defining the pathway for dissolution in the unfortunate event that the business or the partnership fails.
Recently I spoke with an owner (let’s call him Sam) who is having problems with his partner (Craig) and needed guidance about the valuation of his ownership interest. Here’s the situation:
In 2012 Sam and Craig started a company as 50/50 partners. Each brought unique talents to the table: Craig was very creative; Sam was talented in sales and marketing. The startup of the business required a loan for equipment, working capital and the signing of a lease. Sam had very good credit and $15,000 cash; Craig’s credit was acceptable, but he didn’t have the cash to match Sam’s investment.
The business was launched amid tremendous excitement and anticipation of the good things to come. And everything started out very well; after three months, they both felt confident that the $15,000 startup capital could be repaid to Sam. This decision was based more on optimism about the future than on good financial management.
The business consumed the working capital borrowed from the bank and needed an additional capital injection to continue to grow – capital that Craig didn’t have and that Sam was not in a position to reinvest in the business, as he had spent his return from the business on living expenses.
Stress escalated between the partners. Craig removed Sam from the bank accounts, stopped sharing financial statements, and began making decisions without Sam’s knowledge or input. The partnership was clearly doomed because trust was destroyed. Sam realized he must leave the business.
But … there was no roadmap to allow Sam to separate from the business despite the obvious necessity to dissolve the partnership. Further complicating the situation, the business loan was secured on the strength of Sam’s credit and he and his wife had signed the loan guarantee.
Sam offered to sell his shares to Craig for $1, but even that would not remedy the problem. The bank would not release Sam from his guarantee because business performance was marginal and Craig’s asset strength was not sufficient without Sam.
With no remedy to the toxic relationship, Sam walked away from the business with his personal guarantee still in place despite having no control over the direction of the business. Two years later, the business continues to just plod along because of Craig’s lack of marketing skills. Thankfully, the bank loan and lease agreement are continuing to be paid.
Sam’s only option is to wait until 2018 to force a resolution when the bank loan comes due and the lease expires. If that does not provide the leverage needed, he may have to force liquidation of the business by withholding his consent to renew/guarantee the note and the lease.
Sadly, the only potential value is Sam’s proportional percentage of the asset liquidation value after the bank is paid. And it could get even worse – if the liquidation value of the company assets comes up short, the personal guarantee will leave Sam responsible to the bank.
This mess teaches two important lessons about business partnerships: 1. Create a buy-sell agreement when the company is founded to plan for the exit of a partner. 2. A 50/50 ownership split is not advisable and rarely works. Every organization needs an ultimate decision-maker! Even a 51/49 split works, with the partner who carries the most risk of financial loss and/or puts up the most cash holding the controlling interest.
Dave Driscoll is president of Metro Business Advisors, a mergers and acquisitions business broker, business valuation and exit/succession planning firm helping owners of companies with revenue up to $20 million sell their most valuable asset. Reach Dave at DDriscoll@MetroBusinessAdvisors.com or 314-303-5600. For more information, visit www.MetroBusinessAdvisors.com.