Buying a Business with a Partner (Part 2)
In Part 1, we looked at reasons to buy a business with a partner. These included combining resources, benefiting from an expanded professional network, and the possibility of partnering with the seller.
We also looked at the structure of partnerships at a high level. At their most basic, partnerships are either:
Equal partnerships, where ownership is equally split
Majority-minority partnerships, where one partner holds most of the equity.
Let’s turn to the partnership agreement. What function does it play? What key terms do you need to consider?
As a reminder, I am using the term partnership broadly, not in the sense of a legal or tax partnership. Similarly, I am using the term partnership agreement broadly.
It may be that you and your partner are stockholders in a corporation (and will therefore negotiate a stockholders’ agreement). Alternatively, you and your partner may be members of a Limited Liability Company (LLC) (and will therefore enter into an LLC agreement).
Either way, the following applies.
Why Have a Partnership Agreement?
A partnership agreement fulfills many roles. It describes the partnership’s management structure and economics. It also sets out the partners’ rights and responsibilities with respect to one another.
Are you legally required to have a partnership agreement? Not necessarily. Depending on the underlying legal entity, few states require it. But without a partnership agreement, you’re at the mercy of:
The background laws that govern partnerships in the jurisdiction in which the partnership is formed.
Whatever verbal agreement you and your partner argue exists when fighting over a dispute in court.
To the extent your search is its infancy, there is no need to rush to have a partnership agreement prepared (there is nothing to fight over). But you should have a partnership agreement in place before investing significant resources.
Key Terms to Consider in a Partnership Agreement.
A lot could be written on partnership agreements. Necessarily, the following is far from exhaustive. We will touch on the following:
Management Structure
Minority Protections
Deadlocks
Exit and Transfer.
1. Management Structure
Most self-funded searchers will rely on corporations or LLCs as the basis of their partnership.
I’ve written about this before.
Corporations
If the underlying entity is a corporation, the corporation will be managed by its board of directors. You and your partner, as stockholders, will designate those directors. The directors will appoint officers to handle the day-to-day.
That all sounds complicated. Is there really a need to have directors and officers?
Yes. A defining characteristic of the corporate form is the split between ownership (stockholders) and management (directors). Many states also require certain officers (for instance, a president, a treasurer, and a secretary).
But before you panic, there is nothing to stop the stockholders from serving as directors and officers. In fact, this is very common in small privately held corporations.
Stockholders’ agreements address the composition of the board of directors. Corporate bylaws typically address the appointment and tenure of officers.
Limited Liability Companies
If the underlying entity is an LLC, you have a different set of options. While members own the LLC, management can be handled by:
The members (collectively)
A designated (managing) member
One or more managers
A board of managers.
In most states, managers do not have to be members of the LLC. But in some states, they do. Make sure to check.
Whether managed by members or managers, the managing person or entity in an LLC serves a similar role to that of the director in a corporation. And similarly, the managing person or entity can also appoint officers to handle the day-to-day.
The management structure of the LLC will be set out in the LLC agreement. The LLC agreement will also address the appointment ad tenure of officers.
2. Minority Protections
In Part 1, I mentioned the tyranny of the majority. How do minority partners protect their interests in a majority-minority partnership?
Minority partners have several tools at their disposal.
Veto Rights
Partnership agreements often place limits on what a majority partner can do (either directly or indirectly) without minority partner consent.
This is accomplished through veto rights: A list of major decisions that require majority, supermajority, or unanimous partner approval.
Actions subject to veto rights are decided by a vote of the partners, either in person or by written consent. Voting rights are usually proportionate to each partner ‘s interest in the partnership.
Common veto rights include:
Amending, modifying, or waiving constitutive documents
Authorizing an acquisition, merger, or other similar transaction
Liquidating, dissolving, or winding up the business.
The exact list depends on the structure of the partnership and the circumstances. What's the relative split of equity between the partners? How much leverage does the minority partner have to insist on broad veto rights?
It’s tempting for majority partners to agree to a long list of veto rights. It’s easier than having a hard conversation up front about control But this approach can be counterproductive.
A long list of veto rights will result in a lot of voting and less action. Additionally, veto rights can lead to deadlocks, which, as we'll address later, are bad.
Affirmative Covenants
A minority partner can negotiate affirmative convents.
Affirmative covenant?
It’s legalese: A promise to act or keep a condition constant.
In the context of a self-funded search partnership, these covenants are usually limited to information rights:
Delivering periodic financial statements
Access to the partnership’s books and records.
Remember, knowledge is power.
Regular financial reporting may help a minority partner identify areas where the majority partner is acting in her self-interest rather than in the interests of the partnership. This could be a breach of a fiduciary duty, as discussed in Part 1.
Preemptive Rights
A preemptive right gives a minority partner the right to purchase her proportionate share of any future equity that the partnership issues. It prevents the majority partner from diluting the minority partner’s ownership stake by issuing equity to herself or a third party.
Preemptive rights aren’t always included in the partnership agreement. Minority partners sometimes instead push for a veto right over the issuance of new equity.
3. Deadlocks
A deadlock occurs when the partners fail to reach agreement on a major decision.
This is most likely to occur in:
An equal partnership with two partners where each partner holds 50% of the voting interests
A majority-minority partnership where a minority partner holds broad veto rights.
Whatever the reason, you could be in trouble; depending on the underlying issue, the deadlock could paralyze the business. Partnership agreements should therefore include mechanisms to resolve deadlocks where they are likely to occur.
The least drastic option is mediation.
This is also the easiest option to include. After all, at the outset, partners assume that they will resolve their differences amicably. Mediation is different in degree but not kind from amicable discussions.
But mediation may only get you so far. And like pain medication, there is no middle ground. If mediation is Tylenol, the next step up is OxyContin…
… Forcing one partner from the partnership.
There are many ways to administer this tough medicine.
One partner can notify the other partner that she is offering to buy the other partner’s interest in the partnership or sell her own interest at a stated price. The other partner then gets to decide whether to buy or sell at that stated price. This is affectionately known as Russian roulette.
One partner can notify the other partner that she is commencing an appraisal of the partnership to set a floor price. Each partner can then elect to buy the other partner’s interests or sell their own. If both elect to buy, the partners proceed by auction. If both elect to sell, the deadlock continues.
Each partner sends a sealed bid to an independent party setting out the maximum price that she is willing to pay for the other partner’s interests. The partner with the highest bid wins and must buy the other partner’s interests.
You get the idea.
If mediation fails, you may have to press one of these nuclear buttons. And if so, you may come out on top, you may not. It somewhat comes down to chance (it’s called Russian roulette for a reason).
That is why avoiding a two-person equal partnership is wise. It’s also why majority partners should try to limit veto rights to the extent possible. Deadlocks aren't fun.
4. Exit and Transfer
At the outset, partnerships are filled with optimism and goodwill.
Yet circumstances change, and a partner may want out.
This isn’t a deadlock; it’s a cordial divorce. And whatever the reason, the exiting partner may want to transfer her equity to another person to liquidate her interest in the partnership.
But there is a problem. Partnership agreements typically include a general restriction on transfers. This is so that the partners can control who is admitted to the partnership.
As a result, exceptions to this general restriction are negotiated into the partnership agreement. The goal is to balance the partners’ desire for control with the possibility that they will need future liquidity.
Transfers to a Third Party
Third-party transfers can be made with the consent of the other partner. But in addition, the partners sometimes agree to third-party transfers subject to other rights:
Right of First Refusal
A Right of First Refusal (ROFR) comes into play when a partner receives a third-party offer to purchase her interest in the partnership. It grants that partner the right to sell her interest to the third-party subject to the right of the remaining partner to purchase the interest first by matching the offer.
In essence, a ROFR grants the remaining partner the option to purchase the interest or permit the transfer, but with the added benefit of knowing the identity of the third party (a fact the remaining partner has learned while evaluating the offer).
Right of First Offer
A Right of First Offer (ROFO) requires the exiting partner to offer her interest in the partnership to the remaining partner before offering to sell to a third-party. If the remaining partner declines, the exiting partner can sell to a third party on terms that are no more favorable than those that were offered to the remaining partner.
Because the exiting partner does not need to wait for a third-party offer to initiate the ROFO mechanism, it is less restrictive. But it also requires the exiting partner to set a price without seeing what the market would offer. Additionally, the remaining partner does not necessarily get the benefit of seeing who the third party is before making her decision.
Drag and Tag Along Rights
Drag-Along Rights
In a majority-minority partnership, a drag-along right permits the majority partner (the dragging partner) to sell the partnership without resistance from the minority partner (the dragged-along partner). A drag-along right therefore avoids a minority partner holding up a sale.
While the majority partner can compel the minority partner to participate in a sale, she can usually only do so on the same terms (i.e. the minority partner receives a proportionate amount of the consideration and agrees to the same representations and covenants).
Tag-Along Rights
In contrast to drag-along rights, tag-along rights are a minority protection. If the majority partner sells her interest in the partnership to a third party, she must permit the minority partner (the tag-along partner) to participate on a proportionate basis, typically on the same terms.
A minority partner may resist drag-along rights, as it allows the majority partner to sell 100% of the partnership without owning 100% of the partnership.
Similarly, a majority partner may resist tag-along rights. This resistance may be particularly strong where the minority partner is the operating partner, as a third-party may only be interested in buying the majority partner’s interest if the minority partner stays on to operate the company.
Put and Call Options
A put right gives one partner the right to force the other partner to buy her interest in the partnership at an agreed price (or subject to an agreed methodology).
In contrast, a call right gives one partner the right to force the other partner to sell her interest at an agreed price.
Put and call rights are similar but serve different purposes.
A put right is an exit mechanism. It guarantees liquidity to the holder. A call right is all about control. The holder can force the other partner out.
Permitted Transferees
Partnership agreements often include a transfer exception for permitted transferees—certain persons to whom a partner can transfer her interest in the partnership without the consent of the other partner.
Permitted transferees usually tie into estate planning. For instance, permitted transferees are often trusts (where the partner is the trustee) or family members.
Buy-Sell Provisions
Partnerships between living people are vulnerable to changes in fortune. This includes death, divorce, and bankruptcy. As such, partners often attempt to preempt these events in the partnership agreement.
Whatever the event, the basic mechanism is the same: Upon death, divorce, or bankruptcy of a partner, the partner (or the partner’s estate) is required to sell the partner’s interest back to the other partner at an agreed price.
Partnerships sometimes take out life insurance on the partners to cover any repurchase in the event of death.
In the case of divorce, spouses are required to sign spousal consents that commit them to the terms of the partnership agreement. This is especially important in community property states where the spouse may own a share of the partner’s interest.
Even in partnerships between legal entities (where death, for instance, is not directly at issue), s*** happens.
This is addressed in a change of control provision.
If the ownership of a partner changes, the partner may have to sell its interest in the partnership back to the other partner.
Common Legal Pitfalls to Avoid.
Let's round this out with a couple of common pitfalls.
Informal Arrangements Without Written Agreements
Regardless of whether you partner with a family member, friend, or stranger, make sure you have a written partnership agreement in place before investing significant resources.
Verbal agreements can be binding. But verbal agreements are subject to dispute. And they are also often insufficient to modify the background laws that govern corporations and limited liability companies.
If you don’t take the time to negotiate and memorialize a partnership agreement, you’re leaving yourself exposed.
Failing to Plan for Deadlocks
Whenever I ask a client how they want to resolve deadlocks, they always give me some variation of the same response:
We’re on good terms and will resolve any differences amicably.
That’s naive. Issues may come up that divide you. That's life.
Don’t leave it to chance. Deadlocks can destroy businesses. Mediation and the possibility of Russian roulette are better than a business paralyzed by disagreement.