Things to Know About Partnership Buyouts— Part 1

Chris, I want out of my business partnership. I am entitled to half the value of the business, right?

“Entitled” Is Not the Right  Word

When you want out of your business partnership, you have important rights to protect. But, there isn’t much you are entitled to.

Buyouts between partners are usually mired in things that people think are legal entitlements. To help parties reach fair agreements, I start by addressing the most common misconceptions around buyouts. Let’s take a look at the big ones. Understanding these myths will help buyout talks proceed with less emotional confrontation.

NOTE: These scenarios assume a 50/50 Business Partnership. And, these tips are guidelines. In court, the Great American Funhouse, anything can happen. Finally, all of these myths can be reversed with one simple document: Partnership Agreement.

#1 When Leaving a Business Partnership You Are Entitled to At Least Getting Your Investment Back

FALSE

You may demand ‘return of startup investment’ as part of your price to sell your interests in the business but you are not legally entitled to it. Money invested in starting a business is subject to the ravages of risk. If we use the startup money to buy a warehouse full of products that won’t sell, the current value of the business could be less than what was initially invested. And, things like rent deposits and insurance cost money, but those items don’t translate to direct value.

If you’re ready to sell your partnership interest, set your price based on the value of the  business and not what you’ve put in. When selling your stake, you are not legally entitled to return of investment.

#2 When Leaving a Business Partnership You Are Entitled to Half the True Value of the Business

FALSE

What?! If you own half the business, aren’t you entitled to getting half the value if you want out? No. The price you get from your partner, if there is no Operating Agreement to govern the sale, is whatever she’ll agree to pay you. Period. That’s why it’s so important to get a mediator if you don’t have an Operating Agreement.

A good Operating Agreement contains the necessary terms for a Buyout. Sometimes there is a separate Partnership Agreement. Most of often, the Partnership Agreement is part of the Operating Agreement.

#3 When Leaving a Business Partnership You Are Entitled to Fair Compensation for Your Unpaid Labor

FALSE

Your partner put up $50,000 and you worked for a year without being paid a cent. You’ve lived on your savings. Now things have soured with your partner and you demand payment for the past year plus payment for your half of the business. Here’s the bad news. As a founder, you aren’t an employee and therefore, you are not owed anything for the time you invested.

I often see partners agree to reimburse for unpaid wages. But they don’t have to. When selling your share in a business, you have very little entitlement. Properly conducted negotiations can get you a fair deal.

Again, if you include a clause in your Operating Agreement to cover unpaid wages at some future date or to reimburse wages in the event of an unplanned buyout, you will get the compensation you deserve. Otherwise, it’s up to your partner whether you get that money.

#4 Your Partner Has to Buy You Out if You Decide to Leave the Business

FALSE

This one can be pretty painful. Your partnership has gone to pieces. All you do is argue. You want out. You want is a fair price, nothing wild, and you’ll leave. Your partner refuses to buy you out. He says something like, “you know the business can’t afford to pay anything.” Or, “the business isn’t worth anything. We haven’t even made a profit yet.” I worked with one partnership that was very tense. After a busy run, the partners decided to take a month off and relax. During that time, one of the partners decided that he wanted out. The other partner literally said, “the business hasn’t made money for a month. The there is no revenue. Therefore, the business has no value.”

Not only are partners not entitled to back wages or a fair valuation, they aren’t entitled to a buyout!

How can you get out of a bad partnership? It’s very tough when there is no Operating Agreement. You might be able to sell your interest to a third party, but you’ll need you partner’s approval. Few people want to buy in to a negative environment so the chances on making that work are slim.

#5 If You Reach an Agreement with Your Partner to Buy You Out, It’s Legal to Backdate the Deal

TRUE

It’s June. After some pretty tense negotiations, your partner has agreed to a price. Then he says, “I want to backdate this to the end of last year to make the bookkeeping a lot easier for this year.” Is your partner proposing something illegal? No.

It’s common for really big deals to have effective dates years in the past. This is not only general practice, it’s also legal unless you are backdating to commit fraud.

For example, let’s say you were in a customer’s home and broke a precious Ming Vase. The customer is very angry and suing the business for $100,000. If you take a buyout and we backdate it to a year ago, we can claim that the the business is not responsible for the damage because your involvement with the company ended a year ago. Legal? No.

But, if partners agree, and there is no fraud, buyouts can be backdated. What if the partner has already been paid something in the current year? We can treat that as wages paid. You do not have to be an owner to receive wages, right? That means your ownership status could have ended a year ago but you continued to provide service and receive payment in the current year. As long as we are not committing fraud or trying to conceal some illegal act, we are free to backdate. That makes the current year’s accounting much easier.

Yes! It’s legal to backdate a buyout as long as we are not doing to so to commit fraud. Backdating simplifies the accounting and helps make the break clean.

Summary

You find yourself in a 50/50 partnership and the relationship has soured. You want out. Your partner doesn’t have to pay back wages or 1/2 the value of the company. You are not even entitled to getting your investment back. You can’t sell to a third party. That means it’s impossible to get a fair buyout for your interest, right? No. With mediation and patience, a deal can usually be reached.

The best approach is to create and sign an Operating Agreement BEFORE the partnership relationship fractures. Your Partnership Agreement should provide the rules for how a partner can leave the partnership.

Get that Operating Agreement!

“Buyout talks with a business partner can be strained. If there is an Operating Agreement, the buyout process is a lot easier.”