In a perfect world, business partners who reach the point of parting ways would have a clear, unambiguous plan in place governing their separation. Unfortunately, when they engage in business in the real world, many company owners who need a Business Divorce find that they never adopted any type of separation agreement or that the agreement they have is missing key elements necessary to facilitate a prompt, inexpensive separation. This post therefore outlines a Business Divorce process designed to achieve a prompt, efficient exit plan for business partners.
The Exit Plan Should be Approved When the Investment is Made
For an exit plan to work effectively, it must be adopted in advance, because a successful Business Divorce involves far more than determining a buyout price based on an appraisal that supports the buyer’s or seller’s notion of value. In fact, a “ready-fire-aim” approach that calls for getting an appraisal, and then starting buyout negotiations is almost certain to result in a drawn-out, expensive process that may end with the parties in dispute. To minimize costs and reach an agreed outcome, both parties must adopt a process with a definite end-point—a successful separation.
Establish the Parameters for the Valuation
The parameters for the valuation of the partner’s interest will impact the results so these must be defined at the outset, which requires dealing with potentially difficult negotiations sooner rather than later. While it may be tempting to iron out sticking points later, if the ground rules aren’t established at the front-end, the parties may reach valuations that are miles apart. Then, if there is no agreed-on mechanism to reconcile these differences, the parties will be back where they started (after having incurred the legal fees and cost of appraisals).
These are key parameters to establish in the exit plan:
- Standard of Value. The most common and well-defined standard of value is “fair market value,” which assumes a hypothetical willing buyer and seller who each have knowledge of the relevant facts. Other standards of value such as “fair value”, “intrinsic value” or “investment value” are less well-defined and can lead to conflicts. Therefore, using the “fair market value” standard is the best practice as it is well-understood by appraisers.
- Level of Value. The parties must decide whether discounts for lack of control and lack of marketability apply to a minority, non-controlling interest in the business. While, a non-controlling, minority interest is generally viewed as less valuable, minority sellers will, of course, will seek a valuation on a pro-rata control basis. It should be noted, however, that absent an express agreement to the contrary, the fair market value standard requires consideration of the lack of control and marketability of the interest to be valued.
- Valuation Date. The parties must also determine the date of valuation when, in some cases, a dispute may have been simmering for months or even years. If, the governing documents specify that the valuation must be as of the date the separation process begins, all developments after that date must not be considered by appraisers unless they were reasonably known or knowable as of the valuation date.
The above are just a few examples of the key parameters to be considered before partners start a valuation process. Additional factors are whether the seller is entering into a transition and non-competition/non-solicitation agreement as part of the transaction as non-compete restrictions, or the absence of same, can affect valuation. Both sides should think carefully about how any valuation opinions will be defined and work through those parameters before starting this process.
Defining the Appraisal Process
The parties need to define the process by specifying how the appraisers will function and, in this regard, whether both sides will be heard by all appraisers involved. Ensuring a fair and transparent system for getting information to the appraiser (or appraisers) is fundamental and should be carefully detailed. Some of the fundamental questions to be answered are:
- Will there be a single, neutral appraiser, or multiple appraisers involved?
In most cases a single appraiser will be both faster and more cost effective, but if budgets allow, and the magnitude of the differences is large, the parties want to provide for multiple opinions. If a single appraiser is used, both sides should recognize that the appraiser may end up making both parties unhappy—i.e., reaching a value higher than purchase price the buyer thinks is appropriate and lower than the value the seller considers fair.
- If multiple appraisers, how will their results be reconciled?
If each side retains an appraiser, it is not a good idea for them to simply accept an average of the two valuations, which encourages clients to put pressure on the appraisers to take extreme positions. The parties should, instead, consider adopting a threshold of difference (such as 25%) and if the two values are beyond that percentage difference, the parties should then require a third, neutral appraiser to be retained to reconcile the differences or to prepare a third appraisal. Alternatively, the process can allow for an informal mediation process to take place once the two appraisers determine their values. Unless there is a requirement that forces the appraisers to agree (and the parties to transact at the agreed value), however, an agreement that simply calls for the two appraisers to meet to reconcile their different valuations will likely not bring closure to the process.
- Who retains the appraiser(s)?
If a single appraiser is retained, having the parties jointly retain and pay for the neutral appraiser will remove any concerns that the appraiser is biased in favor of the party who is footing the bill. The appraiser may request that the entire fee to be paid up front, however, to avoid seeking payment from clients who may not be happy with the valuation report.
- What is the deliverable?
In efforts to minimize cost, the parties may be tempted to request a bare-bones valuation report that does not include a detailed description of the methods and assumptions used. If that approach is taken, however, it may leave the parties feeling as if the entire process is a “black box” with no opportunity to evaluate and comment on the appraisal.
- How will data and information be communicated to the appraiser(s)?
The ultimate goal is to make sure that both sides are involved in the process. Therefore, both sides should be included on all communication providing information to the valuation expert. If multiple valuation experts are involved in the process, it is helpful if all of the experts receive identical packages of information.
- What will be the format of the management interviews?
Both sides should participate in management interviews with the valuation expert, and if things are amicable between the parties, both sides can participate in the same management interview session. In more contentious cases, each side may need to be interviewed separately. If all partners retain valuation experts, if feasible, both experts should participate in the same management interviews.
- When, and to whom, will results be communicated?
The valuation experts must submit all of their reports and preliminary indications to all parties who have an ownership stake in the business. In most cases, the best practice is for all valuation experts to provide the full deliverable (reports in draft or final form) to all parties at the same, designated time.
- Will the parties be permitted to comment on the report(s) or are results final?
It is common for business valuation experts to issue a draft report and allow the recipients to provide comments before the report is finalized. This allows for the parties to identify areas where the valuation expert may have misapplied the law or where the data is flawed in some manner. This process may however result in intense lobbying on the part of the parties, so the process should allow only for changes that relate to objective facts, application of law, or correction of errors.
- Will the parties be obligated to transact based on the outcome?
If there is no formal buy-sell agreement in place governing the Business Divorce, the parties may have no obligation to transact at the end of the process. Since invariably one party or the other (or often both) will be unhappy with the conclusion, if there is no mechanism to force a transaction, the whole process may become a hotly contested dispute. If the goal is to achieve finality in the separation before starting a process, the parties will want to make sure there is a clear and defined end by entering into a legally binding agreement to transact at the valuation determined through the buyout process.
A Business Divorce can be long, expensive, and emotionally challenging process. Defining the steps of this exit plan as early as possible, therefore, in well-thought-out, clear, and actionable steps set forth in a binding agreement should help achieve a partner exit more promptly and in a manner that is subject to fewer disputes. In sum, the exit plan should be negotiated and put in place before a partner exit is imminent and, ideally, an exit plan should be adopted when the business co-ownership is first established. Exit planning when the investment is made will help to secure closure at a fixed point, and this type of exit planning will allow one party to return to focus on running the business while the other party moves on to a new business venture.