The statistics are grim on relationships remaining intact between business partners. This month’s edition of Inc. magazine cites Noam Wasserman, entrepreneurship professor at USC’s Marshall School of Business, reporting that 10% of co-founders end their business relationship in less than one year and 45% break-up within four years. While these statistics are focused on two-person owned companies, break-ups are at least as common among businesses with multiple owners. Faced with these distressing figures, this post focuses on concrete actions that business partners can take at the outset when their company is formed or when an investment is made, which our experience teaches will improve their prospects for maintaining long-term business relationships.
Operational issues and the vision for the company can definitely lead to disputes, but in many (if not most) cases, the crux of the conflict between business partners comes down to a disagreement over money—how the financial pie will be split. Our suggestions therefore key on how the company’s finances are handled. The starting place is to put an exit plan in place at the outset of the relationship —a Buy-Sell agreement that governs any future Business Divorce. This “corporate pre-nup” will help avoid litigation and a huge distraction for the company when a partner departs. We have written extensively on this topic in previous posts (see links below), and adopting a partner exit plan is essential.
- The Perfect Buy Sell Provision
- A Win-Win Buy Sell Agreement
- Hope for Minority Investors Who Failed to Obtain a Buy-Sell Agreement Before Acquiring Their Interest
- Buy-Sell Agreements: Don’t Leave Home (Or Invest) in a Private Company Without One
But the Buy-Sell Agreement only comes into play when business partners are separating. There are three specific steps that partners can take when their relationship begins, which will help limit their conflicts and, perhaps, avoid the need for a Business Divorce in the future. These steps are: (1) adopt a dividend/distribution plan, (2) implement an executive compensation plan or formula and require annual valuations of the company prepared by an independent business valuation firm. Each of these actions is discussed below.
The Dividend/Distribution Plan
Most investors are seeking both a short-term and a long-term return on their investment. The long-term return comes into play when the investor exits the business either at the time the company is sold or when the investor sells his or her interest to another party. Before that type of liquidity event takes place, however, the investor is looking for a current return in the form of a dividend or distribution of company profits. When the majority owner decides to stockpile all of the company’s earnings and declines to issue any dividends or distributions, this can lead to sharp conflicts with the other owners of the business.
The problem becomes even more acute if the failure to issue dividends/distributions results in phantom income attributed to the owners. Phantom results in pass-through entities like LLCs and limited partnerships when the K-1s issued to the owners reflect profits generated by the company on which the owners are required to pay income taxes, but the company declines to distribute any funds to the owners that they can use to pay their resulting tax liability.
To avoid the phantom income problem, private company investors will want to ensure that the company’s governance documents require the majority owners to distribute sufficient actual income to all owners to cover their tax liability based on their ownership in the business. Business partners should go further, and consider whether to adopt a dividend plan/formulas that would require the company to distribute at least some portion of “excess profits” generated by the business. The dividend plan is not an easy or simple formula for partners to develop, but the goal is to allow the company to retain sufficient earnings that enable the business to grow and prosper, while at the same time requiring at least some portion of the profits to be received and enjoyed by its owners on a current basis. The company’s governance documents should also allow the flexibility for the dividend plan to be adjusted over time by the mutual agreement of the owners as the company’s needs for capital change and evolve.
Executive Compensation Program
The compensation the company pays to business partners who are also executives is often a major sore point among them. The majority owner is frequently viewed as being overpaid by the minority members. And in some cases, the majority owner feels like the minority owner-employees are receiving too much compensation for providing too little value to the company. In addition, once these strong resentments have built up over time, it may not be possible to resolve the difference of views in a way that can avoid a Business Divorce.
An effective way to head off this problem is to establish both a compensation formula at the start of the relationship for top executives and to provide a mechanism for adjustments to be made over time based on professional input from an objective compensation expert. As with a dividend plan, adopting a compensation formula will not be simple or easy to implement. The effort that is required to put a compensation plan in place, however, will require the partners to participate in a meaningful discussion of their expected compensation levels, as well as their expectations for the performance necessary to receive the desired level of compensation.
Annual Business Valuation Reports
The desire for a long-term return is the primary reason that people create and invest in private companies – building or supporting a business that achieves significant value which can ultimately be realized at some point in the future. The question posed therefore seems simple – what is the business worth? Unfortunately, partners’ perspectives on the value of their jointly-owned private company often include subjective aspects that lead to widely varying views about its true value. These valuation disparities only become more pronounced over time and can cause a partner to head for the exit and result in a major (and expensive) legal fight over valuation.
The solution is to pre-empt the valuation fight. Specifically, if the company obtains an annual valuation as of December 31 each year from an outside, independent valuation firm, the existence of these periodic valuation reports from a neutral expert sharply reduces if it does not eliminate the huge variance between partners’ views on the company’s value. If all partners in the business have an accepted value of the company, they don’t need to file suit to determine the value of their interest in the business. These valuation reports will therefore help avoid conflicts between the partners and may stave off a Business Divorce.
With marital divorce rates either at or exceeding 50%, it is hardly surprising that business partners also find it difficult to maintain long-term relationships in their companies. And just as disagreements over finances are a primary cause of marital divorce, business partners also frequently have conflicts over the way that the company spends and allocates available funds. For this reason, we are strong advocates for business partners to engage in pre-planning with a focus on financial
Business partners who consider, develop and implement plans to handle distributions, executive compensation and valuation of the company have created a far stronger prospect for achieving long-term success for themselves and for the business as a whole. These proposals, if implemented are not without cost, but in comparison to the legal and collateral costs of a hostile Business Divorce, these proposals provide an excellent value proposition for business partners and for their companies.