/>iBusiness divorces often involve turbulence as business partners go through this process. But partners who plan ahead can navigate through their business divorce to avoid capsizing the company or frustrating their personal business objectives. This type of planning requires each of the partners to (1) review and understand the terms of the agreements in place that govern their separation, (2) develop a real world, objective appraisal of the value of the interest that is being transferred, and (3) consider the business issues that may arise for both sides after the divorce, e.g., future competition by the departing minority partner.
The change and separation involved in a business divorce can be hard for all parties, but anticipating the issues that are likely to arise provides a compass for partners that will help them chart a predictable course to smooth sailing on the other side of the transaction. In the following post, we will consider the goal of becoming prepared for a business divorce from the perspective of both the majority owner purchasing the interest of the departing partner and the minority investor whose ownership interest is being purchased.
Step 1: Closely Review the Written Agreements That Apply to the Business Divorce
The first step in approaching any business divorce is to know the rules of the game.
The Majority Owner
The majority owner needs to understand whether a buy-sell agreement exists that allows the owner to redeem the interest held by the minority investor or that will permit the investor to demand a buyout. If this type of agreement is in place, it governs the manner in which either party can exercise a call or put option that will result in a redemption of the minority interest. In either case, the agreement will address how the value of the minority interest is determined, and it will also set forth the payment terms after the value of the interest is determined.
In the absence of a buy-sell agreement, the majority owner does not have the right to trigger a repurchase of the minority interest and therefore has to negotiate with the investor to find terms that are acceptable. If the investor demands payment of an excessive amount or insists on including unreasonable terms, it is likely that a buyout will not take place in the near term. In this scenario, the majority owner will have to consider taking actions that cut off all further economic benefits to the investor before a liquidity event takes place that cashes out the investor’s interest in the business. This is known as a freeze out or squeeze out situation.
Minority Investor
The minority investor also needs to determine whether a buy-sell agreement exists that permits the majority owner to exercise a call right to redeem the minority interest or that authorizes the investor to exercise a put right, which requires the majority owner to purchase the investor’s interest. The terms of the buy-sell agreement are therefore critical to fully appreciate before a business divorce is considered.
If no buy-sell agreement is in place, the good news is that the minority investor cannot be forced out of the business by the majority owner on terms the investor considers unfavorable. The bad news, however, is that the investor cannot require the majority owner to purchase the investor’s interest for the price desired by the investor if the investor wants to exit the business for any reasons. Without a buy-sell agreement, the minority investor must assess whether leverage can be obtained that will bring the majority owner to the table to discuss a buyout. This leverage may be available if the majority owner has engaged in self-dealing in managing the business. The bottom line is that the minority investor needs to evaluate the majority owner’s conduct to determine whether any misconduct by the owner will provide some leverage that the investor can apply to facilitate a buyout discussion with the owner.
Step 2: Develop a Real World (Objective) Assessment of Value
The next critical step for the partners to prepare for a business divorce is to understand the actual fair market value of the minority interest that will be changing hands.
The Majority Owner
If a buy-sell agreement exists, it will specify the method the parties must use to determine the value of the minority investor’s interest that is being purchased in the business divorce. If no buy-sell agreement exists, the majority owner will need to negotiate the purchase price directly with the minority investor. At the outset, the majority owner typically directs the company to retain an independent valuation expert to determine an objective value of the minority interest that the parties can use as the basis for their negotiation of the purchase price.
Under these circumstances, however, the majority owner should expect the minority investor to demand payment of a premium for the minority interest, because the investor has no contractual duty to sell. As long as the minority investor’s proposed purchase price is within the realm of reason, the majority owner who wants to purchase the interest should seriously consider paying a premium of some amount, because (1) the owner will secure the return of the investor’s equity in a manner that avoids a prolonged exit, (2) the purchase of the investor’s interest will avoid incurring any legal fees dealing with claims or litigation by the investor, and (3) the owner will capture all future appreciation in the value of the business.
Minority Investor
As noted above, the minority investor cannot renegotiate the purchase price for his or her interest in the company if a buy-sell agreement exists that dictates the process for determining the value of the investor’s interest. When there is no buy-sell agreement, the minority investor can choose to hold out to secure a purchase price that reflects full market value of the investor’s interest. As a cautionary note, however, the majority owner has no contractual obligation to purchase the investor’s interest in the absence of a buy-sell agreement. Therefore, if the investor drives too hard a bargain in the negotiations, the owner may simply walk away from buyout discussions and also terminate all distributions or dividends to the investor. As a result, the investor who insists on receiving top dollar for his or her minority share of the business, must be prepared to wait a very long time to be in a position to monetize his or her interest if the majority owner is not prepared to pay what the investor perceives as full value for the minority interest.
Step 3: Consider Post-Separation Business Issues
The final step in preparing for a business divorce concerns the need to consider what will take place after the business divorce has been completed.
The Majority Owner
For the majority owner, the planning process needs to address how the company will operate after the minority investor departs, which is more of a significant issue if the investor had an active role in the business. If so, the majority owner will need to take steps to arrange for a smooth transition of all duties previously handled by the investor relating to customers, vendors and the supervision of other company employees.
The majority owner will also want to ensure that the departing minority investor does not create problems for the company after leaving. First, the majority owner will want to retrieve all confidential information that is held by the investor as part of the business divorce. Second, the majority owner needs to consider whether to request the minority investor accept restrictive covenants that prevent the investor from competing with the company and from soliciting its employees for some period of time.
If the majority owner believes these restrictions on the investor are necessary, the owner will likely have to pay additional consideration to obtain them in addition to the purchase price that is paid to the investor for his interest in the business. The majority owner should require that this additional amount be paid to the minority investor over time so that the unpaid amounts can be withheld if the investor fails to comply with the restrictive covenants during the period that they remain in force.
Minority Investor
The minority investor does not need to retain confidential information that belongs to the company, but the investor does need to decide to what extent she has any interest in remaining active in the same industry as the company. If the investor wants to remain active in the industry in some capacity, the investor needs to make sure that complete clarity is reached regarding the exact scope of any restrictive covenants that the owner seeks to impose on the investor’s future conduct. The extent of the restrictive covenants will also impact the amount that the minority investor seeks as additional compensation for accepting these new restrictions.
But, if the minority investor is receiving a fair price from the majority owner for the purchase of the investor’s minority ownership interest in the business, the investor should be wary of overplaying his or her hand. If the minority investor seeks too much compensation from the majority owner in payment for the restrictive covenants that are requested by the owner, the investor may cause the entire deal to fall through and lose the opportunity to monetize the minority interest in the business for a reasonable price.
Conclusion
Most business divorces include some rough waters to cross for the partners, but if they plan ahead, they can successfully weather the storm. This advance planning requires the partners to (1) develop a keen understanding of their contract rights based on the terms of the agreements in place, (2) determine the objective, fair market value of the minority interest that is being sold in the business divorce, and (3) consider the business goals of the other partner after the business divorce has been completed.
This careful planning by business partners will enable them to navigate their way through a business divorce in a manner that saves them time and expense, preserves their relationship, and also avoids running the business into rocky shoals.
