The Enemy Within: Protecting Your Assets from Your Partners

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Digital Library > Building and Inspiring an Organization > Partnerships"The Enemy Within: Protecting Your Assets from Your Partners"

Few entrepreneurs plan to fight with their business partners. But disputes among partners are all too common, bitter, and costly — particularly when one partner wants to sell out but can't find a buyer. Fortunately, you can often head off difficulties with your partners before they escalate to the point of no return and double legal fees (a.k.a. litigation).

Few Entrepreneurs plan to fight with their business partners. But disputes among partners are all too common, bitter and costly — particularly when one partner wants to sell out but can't find a buyer. Fortunately, you can often head off difficulties with your partners before they escalate to the point of no return and double legal fees (a.k.a. litigation).

DRAFT A BUY-SELL AGREEMENT.

A buy-sell agreement can help avoid the problem of how to handle an unhappy partner interested in selling out. For starters, the rights spelled out in the agreement should apply equally to all partners — at the start, you never know which of you will be the buyer and which will be the seller. The agreement should prohibit any partner from transferring his interest in the business to anyone else, by choice or otherwise. This protects the others from being forced into business with someone with whom they don't care to do business. The agreement also may include a "shoot out," which allows a partner to set a price at which he will buy another partner's shares, or sell his own, in the most difficult cases.

PLAN FOR A PARTNER'S DEATH OR DISABILITY.

Typical buy-sell agreements require the company and surviving partners to buy a dead or disabled partner's share in the business — both to keep control of the business, and to assure the departing partner's family is fairly compensated.

ATTEMPT TO RESTRICT THE SALE OF THE BUSINESS.

"Attempt" is the operative word here, since no law can totally prohibit a person from selling his property. But a buy-sell agreement can require the firm to first offer to sell an interest in the business to the other partners or the company itself, before allowing any unrelated person to buy it. If the partners don't want to, or can't buy it, the interest then may be transferred to another buyer. And the agreement should provide ironclad protection against involuntary sales — through the distribution of assets in a divorce or as an attachment by a creditor, for instance.

SET A FAIR PRICE FOR BUYOUTS.

Most agreements outline one of several formulas to compute a buyout price. "Appraised fair market value" is the most accurate measure — and one is required in a death buyout, to assure that all estate tax due is paid. But most small businesses can't afford the cost of an appraisal, and most don't want to burden their survivors with an unknown payment amount determined at a later time. Instead, partners sign a "certificate of agreed value" that fixes the buyout price in advance. To keep the price current, it's critical to update the certificate at least once a year and after any major increase in the business' value. Another technique is to use the "book value" of the firm — typically the worth of its assets as listed on the balance sheet, minus any debts.

SPECIFY REALISTIC PAYMENT TERMS.

Most agreements require third-party buyout offers to be paid in cash, while offers from other partners can be paid through an installment note (with the interest rate specified in advance). If a death buyout is made and funded by life insurance, the agreement usually requires the buyer to make a substantial downpayment at the time of purchase. In any event, the buyout terms should create payments that are affordable for the business and remaining partners, since excessive payments can destroy a business by draining its cash flow. Keep in mind, too, that the disability or retirement of a partner is a much more likely event than death — which means life insurance probably won't be available to fund a large buyout payment.

EXPLORE ALL THE POSSIBILITIES.

Setting a buyout price and terms will probably help you avoid the most common partner disputes, but the potential for other land mines still exists. For instance, Subchapter S corporations should take extra care to avoid tax problems for the partners in the event of a buyout. The agreement should require cash distributions to pay each partner's estimated taxes, and should bar partners from doing anything that might jeopardize the special tax benefits of an S corporation.

PROVIDE FOR THE CONTINUATION OF "BUSINESS AS USUAL."

A good buy-sell agreement can help avoid disputes about normal management decisions, too. Partners can agree in advance on how they will vote each year for the board of directors, president or managing partner, and other officers. Some agreements include "cash calls," or agreements to contribute additional funds to the business as needed. Others protect the business by prohibiting a partner from competing with the firm for a specified time, or by prohibiting the disclosure of confidential information.

A buy-sell agreement is a relatively inexpensive form of protection, but one that can avoid a great deal of trouble down the road. Without it, the settling of disputes may end up at the mercy of judges and juries — with far less definite rules in place, and at least two lawyers' meters running. In the worst cases, the business may be liquidated (usually at far less than market value) or a custodian may be appointed to manage the business until the dispute is settled. Clearly, none of these scenarios is attractive.

A popular ad campaign for a premium auto parts maker once cautioned, "You can pay me now or you can pay me later." Likewise, entrepreneurs can incur a modest cost for a properly crafted buy-sell agreement, prepared by an attorney specializing in small business law — or face the open faucet of a trial, if the dispute goes to litigation.

About the Writer: Stanley P. Jaskiewicz is an attorney with the Philadelphia law firm of Spector Gadon & Rosen. A member of the firm's Business Law Department, he assists businesses on a wide range of legal matters, including contract law, secured lending, negotiated acquisitions, intellectual property, and regulatory issues.

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