Plan for the Day a Partner Wants to Leave the Business

Chris,

I can no longer work with my business partner. He’s constantly taking money from the business isn’t doing his share of the work. When we talk, it always causes an argument. I want out. We don’t have a Partnership Agreement for you to review. How do we go about this? I need out sooner than later. 

If You Wanted to Leave Your Partnership, How Would It Work?

If you have read my other posts, you know I strongly encourage people who form Partnerships to create a Partnership Agreement. The document must specify how a Partner can leave the Partnership voluntarily while ensuring that the business is protected from two potential disasters: firstly, by avoiding terms that could bankrupt the business, and secondly, by preventing the admission of unplanned Partners.

The focus of this post is on the voluntary withdrawal of a Partner. Your Partnership Agreement should cover the death of a Partner, disability, and the abandonment of interest (a Partner just stops participating). Planning ahead saves you from some pretty tense negotiations and even the possible destruction of the business.

What Is a Partnership Agreement?

A Partnership Agreement is a legal document that outlines the terms and conditions of a partnership. It is important to include provisions that address the process for a partner to voluntarily leave the partnership. Let’s look at the key provisions that should be included.

#1 Notice Requirements

When leaving a job, it’s considered appropriate to give the employer some notice. That’s because when good people leave, it impacts the business. Providing notice gives management time to hire, and hopefully, train your replacement. Imagine the impact on a business of an owner leaving! There is a lot to consider. What message will the business give to the public? Will the change spook your vendors or creditors? Will employees leave?

The Partnership Agreement should specify the amount of notice a partner must provide before leaving the partnership. This notice period gives the remaining partners time to prepare for the departure and to begin the process of finding a replacement partner. And, because a Partner has considerably more effect on daily operations than a part-time employee, it’s not unreasonable to require as much as a year’s notice. That might sound like a long time, but when faced with such a seismic shift in ownership, that may not be enough time depending on the business. For now, just know that more notice is better than less. A long notice might even discourage a Partner from asking for a buyout.

#2 Valuation of the Partnership Interest

The Partnership Agreement should include a provision that outlines the process for valuing the departing partner’s interest in the partnership. This process should be fair and reasonable and should take into account the current value of the partnership and how to make clear how the value will be calculated for a buyout in the future.

This is a provision that many lawyers miss. You want a clear and indisputable method for calculating the value of the business on any given day. The idea is to avoid a provision that will only cause more tension later. I often see things like “the partners will obtain an appraisal by a qualified party to determine the value…”  And they say, “If the parties still cannot agree on valuation, they will use mediation.” What? So basically, we argue over which appraiser to hire, then, when we get the appraisal, we argue over that? And then we head to Mediation? This process is more like Thunderdome than a civil buyout.

I recommend a formula that anyone can use to reach the same answer. For example, you can use a multiple of NET Profit. We can use the last complete year’s P&L as our base. 3X NET is reasonable plus any REAL assets like vehicles, buildings, and cash reserves. Or, you might use 1 year’s annual revenue. The key here is to define a method to determine the value that anyone can use and everyone will arrive at the same number. If you want out, it’s a simple calculation to arrive at the value of your interest. I sometimes use a “Statement of Agreed Value”. The Partners meet annually and update it with a new value. After all, you know the real value of your business better than anyone. And, if things get tense and the Partners cannot agree on a new value later, you simply include a provision that says the value will increase by 5% per year if we, the Partners, do not issue a new Statement of Agreed Value.

Remember! If you document this in your Partnership Agreement, it becomes “law”. If there is a Partnership Agreement, it governs exactly how a Partner leaves the Partnership. Without it, you have a potentially big problem that if it ends up in court can lead to the dissolution of the business. Whatever method you use, having a clear path to an agreed value will prevent the most common issues that come up over buyouts.

#3 Payment Terms

The Partnership Agreement should specify the payment terms for the departing partner. The payment may be a lump sum payment or a series of payments over time. The payment terms should be reasonable and should not unduly burden the remaining partners. (Remember that we don’t want to bankrupt the business when buying out a Partner!)

You might go with 25% paid at closing, the balance over 5 years at 5% or something like that. Keep in mind, most people who are selling their interest are not going to want to be paid out over 30 years unless the payments are quite large.

The key point here is to define these terms in advance.

#4 Restrictive Covenants

The Partnership Agreement may include restrictive covenants that prevent the departing partner from competing with the partnership or soliciting clients or employees for a certain period of time after leaving. I also like to see a Non-Disparagement clause that says that neither party will say anything negative about the other. Keep the laundry in the laundry room.

#5 Dispute Resolution

The Partnership Agreement should include provisions for resolving disputes related to a partner leaving the partnership. This may include mediation or arbitration. This is pretty basic but wise to include. This clause prevents disputing Partners from lawyering up and rushing to court. Require some mediation or arbitration process before litigation.

It is important to have a well-drafted Partnership Agreement that includes clear provisions for a partner to leave the partnership. This can help prevent misunderstandings and disputes in the future.

Remember, this Agreement does not apply if you get an offer from an outside party who is interested in buying your business. In that case, sell for as much as you can get! 

“People in Partnerships will save a lot of grief in the future if they specify how a Partner can redeem shares and leave the Partnership.”