7 steps that can help you avoid ending up in court
Just like a marriage, no one goes into a business partnership expecting it to end. And that makes it all too easy to forget to include one of the most important elements of a partnership agreement: the exit strategy. Or even worse, to not bother setting up a formal partnership agreement at all.
Up to 70 percent of business partnerships ultimately fail – and when they do, it’s essential for the dissolution to go as smoothly as possible to avoid personal and financial headaches. Business partnerships break up for many reasons, and it often has nothing to do with bad blood between the partners. One partner may become incapacitated, for instance, or need to retire or change careers. Generally, these situations lead to uncontested departures in which the other partners understand changing circumstances and the partnership ends amicably.
But other times, things don’t go so smoothly, and the dissolution becomes contentious. Hiring a skilled attorney to create a written partnership agreement when a partnership is formed sets the stage for breakups to proceed as cleanly as possible. Most agreements outline how the partners will run the business, detailing how decisions are made, how responsibilities are divided, how disagreements will be resolved, and a dissolution strategy.
This strategy typically includes a “buy-sell” agreement that stipulates conditions surrounding a partner’s exit, including a formula for valuing privately-held shares by verifiable metrics, what situations can trigger a buyout, who is permitted to buy shares, and how quickly or slowly sales may take place.
Partnership agreements are not required by law but, at the end of the day, it’s risky to proceed without one. If there is no agreement in place, partners will need to be able to work out terms together when they want to part ways – which can be tricky if the reason the partnership is breaking up comes down to an inability to see eye-to-eye. If the partners can’t agree, mediation is often a smart strategy. Court-dictated decisions should be a final resort as they can be costly and often simply divide assets and liabilities 50-50 regardless of the reasons behind disputes.
If you find yourself needing to leave a partnership without an agreement that details how a break-up will unfold, you should ultimately consider seeking legal advice. The type of partnership and status of the departing partner will impact the final outcome, but here are seven steps that can help you execute a clean dissolution of a business partnership when there isn’t a pre-existing strategy in place.
7 steps to ending a business partnership
- Consult with a lawyer. It’s wise to meet with an attorney if you want to end a business partnership. An experienced business law attorney can help you understand state law and the impact of any relevant agreements, such as company bylaws or controlling documents. A word of caution: Be sure to hire your own attorney instead of using the partnership’s lawyer, whose loyalty is to the company as a whole instead of you.
- Consider the state of the business. Before you discuss leaving, make sure you have a firm grasp of the health of the business. Explore how much it’s worth and keep in mind that the assets and liabilities you receive if the partnership dissolves will correlate to your ownership interest. Consider what contracts, liens, mortgages, or other personal agreements you are locked into and will be held personally responsible for – even if the partnership dissolves. You can also have the partnership appraised by a business valuation service, though this will make the other partners aware that you may leave.
- Stay friendly. If there isn’t an agreement that spells out departure terms, it’s important to keep negotiations as amicable as possible. Partners that communicate well are much more likely to stay out of court. You may be able to agree to sell your stake in the business to an outside party or the other partners could agree to buy your shares. Again, it’s vital to consult with an attorney during this process to ensure your interests are protected.
A “Texas shoot-out” is a common way of breaking up a deadlock over ending a partnership, essentially operating as an “I cut, you choose” method of settling disputes. Put simply, one partner elects to “cut the cake” by setting the price for the company and the other partner “chooses his slice” by deciding whether to buy out the first partner or sell his ownership at that price. But there is a caveat: while Texas shoot-outs are often proposed as an easy way to settle disputes, they can lead to abuse by the wealthiest owner, who simply sets a price the other can’t afford.
Another option is to refrain from dissolving the partnership completely and create an agreement that changes the weighting. This typically gives one partner a majority stake and the ability to make decisions alone, and the less-committed partner an opportunity to stay involved while relinquishing some of the headaches and control.
- Explore mediation. If you are struggling to reach an agreement with the other partners on the terms of your departure, mediation can be a good solution. All interested parties will meet with a third-party, neutral entity, who listens to all sides and helps the partners achieve mutually acceptable terms. While mediators do charge for their services, it is almost always less expensive than getting involved in a lawsuit.
- Create a dissolution plan. Even if a partnership agreement is in place, you need to create a plan for dissolving the partnership. It should include:
• A timeline that goes all the way through filing the final tax return
• A detailed list of tasks that need to be performed
• A schedule of payments that must be made, including who should make them
• Documents to be filed
• Plans for notifying stakeholders, including employees, vendors, and customers
- Start to separate. Once you have assessed assets and liabilities and come to terms with your partners, it’s time to start extricating yourself from the business. Simply contacting clients and telling them you’re leaving isn’t enough. Generally, you can’t erase your liability without canceling or renegotiating loans or contracts. If that can’t be done, consider setting up a company escrow account from which obligations will be paid. The partners can also sign documents personally indemnifying the departing partner, but that can quickly become complicated and requires the advice of counsel.
An attorney should help you write a separation agreement that details exactly who owes what, so there can be no disputes or claims against you down the road. Even if the departure is uncontested, you never know what can happen if the company faces an unforeseen crisis or supersized tax bill.
Once this is completed (and executed by all the partners), take steps to remove your name from all company documents, including loans, leases, and contracts. You also need to make sure any commitments the company makes to you are enforceable, and that you understand the steps you can take if the partnership breaches its obligations. Other important items to address in a separation agreement include mechanisms for ensuring debts from which your name can’t be removed or paid, a right to audit the company’s books if you are owed money in the future, and how your name will be removed from documents in cases where it can’t happen immediately.
- Dissolve the partnership. Dissolving business partnerships are governed by state law, so it’s important to get up to speed on the statutes of your particular state – especially when there is no agreement in place to detail how the separation will happen. It usually takes about 90 days to end a partnership from the time a statement of dissolution is filed. The process strives to ensure that partners won’t be held responsible for each other’s debts and liabilities and that they can’t enter into a binding transaction on behalf of the partnership.
There are usually no tax consequences for dissolving a partnership, but you will need to account for the business-owned property that has appreciated in value and payment of business and employer taxes. You do need to inform the tax authorities that you are no longer in a partnership when you file your final return.
Ending a partnership can feel like ending a marriage – and become just as complicated and contentious. It’s always preferable to have a partnership agreement in place that details an exit strategy. But when one doesn’t exist, a skilled business advisor can help guide you through the process.
Provident CPA & Business Advisors serves successful professionals, entrepreneurs, and investors who want to get more out of their business and work less, so they can make a positive impact in their lives and communities. Typically, our clients reduce their taxes by 20 percent or more and create tax-free wealth for life. Contact us for expert advice on tax planning, and to find out how we can help your business exceed your expectations.