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Throwing the baby out with the bath water is a pithy expression that suggests exercising caution when business partners in private companies are seeking to achieve a business divorce.  The majority owner and the departing minority partner in the business may both see this process as a “take no prisoners” type of battle. But adopting the view that a zero-sum outcome is the only possible result when a business divorce takes place — with just one clear winner and loser — is not just unnecessary, it can be destructive to the parties’ relationship and to the business. When parties instead consider creative strategies that are designed to optimize the result for both sides, they will ratchet down the emotional tensions involved, preserve their long-term relationship, and avoid doing serious damage to the company’s reputation and performance.

In this post, we consider a variety of approaches to business divorce that provide for a partner exit based on objectively reasonable terms, which will help preserve the company’s value and provide a structure that enhances the company’s longevity. 

A Phased Buyout with Security Protections

A business divorce involving a full cash payment up front is rarely optimal for either the majority owner or the minority investor. The company will be reluctant to fund an immediate cash buyout from the business, because this sudden removal of the cash on hand will negatively impact the company’s ongoing operations. The departing minority partner will also likely be concerned that insisting on an all-cash buyout will result in an effort to apply deep discounts to the purchase price, i.e.,force a buyout of the minority interest “on the cheap.”

The reluctance of both parties to push for an immediate payment is why it is customary for business divorce buyouts to take place over an extended period. The parties will implement a valuation process using an objective third-party valuation firm to determine the enterprise value of the company; in some cases, both the company and the minority investor will retain business valuation experts to compare reports to achieve an objective resolution of the company value.  Once the value has been agreed on, the parties will put in place a multi-year payment plan for the purchase of the investor’s interest. The investor will also want some form of security in the event of a default in payment, and this can be provided in a number of ways. Some examples include providing a pledged interest in some of the company’s assets or receivables, the majority owner providing a personal guaranty, or the unpaid purchase amount due could be subject to a security interest in a portion of the company’s stock.  

Performance Based Buyouts

When business divorces do become contentious, the business partners are usually in conflict over the company’s value — typically when the majority owner has presented a buyout figure that the minority investor considers much too low. When this valuation dispute results in an impasse between the parties, the filing of a lawsuit may seem like the inevitable next step. But moving to the courthouse is not the only way to resolve this valuation conflict. .

One way to head off litigation over valuation is to provide for the minority investor to receive additional payments that increase the total purchase price paid for the investor’s interest based on the company’s future performance. The majority owner (or company) still acquires the full ownership interest of the minority investor at a closing, but the investor will also receive a (negotiated) percentage of the company’s future revenue for some period of time.

This is known as a revenue-sharing agreement – the purchase price involves payment to the investor of a fixed amount with additional payments that are based on the company’s future performance. The percentage of the revenue share does not have to be flat, i.e., it could be 15% of the revenues the first year, 10% in year two, and 5% in year three — all of these amounts are subject to negotiation. Further, the parties can also include a high-low arrangement that adds both a floor and a ceiling for the future payments. In this scenario, the investor is guaranteed to receive a total minimum amount based on future payments that are made regardless of the company’s actual revenue, which sets the floor for the total purchase price to be paid. If the investor negotiates to include a floor as a guaranteed minimum payment, however, the majority owner will then include a cap that will establish the maximum amount that the investor has the potential to receive based on the revenue share. 

Dividing Assets, Markets or Clients Than Cash

One of the most creative approaches to achieving a business divorce is to structure the buyout based on the assets of the business rather than using cash alone to fund the purchase of the departing partner’s interest. This is an unusual option that will not work in many companies or where partners do not wish to continue operating any part of the business, but when the facts make it possible, this path may help to avoid conflicts and/or a legal battle between the partners. 

In this type of business divorce, the parties will evaluate all the parts of the business and then divide certain company assets between them. There are no limits to the creativity involved in this process, and the partners can decide how to divide assets, including, but not limited to, the geographic regions or territories in which the company operates, the company’s different product lines, different groups of employees working at the company, or different customers the partners are working with in the business.

When the partners divide assets, they will both usually continue to work in the industry, and they will divvy up the company’s territories, product lines, customers and/or its employees in a manner that they determine is appropriate. This is obviously a more complicated scenario than a simple monetary buyout, but if the partners remain on good terms when they are conducting their business divorce, this type of asset division may be less contentious because each partner will receive the assets they need from the company to be successful as they move forward in the same or similar industry.

Conclusion

Business divorces often present emotional challenges for the partners, particularly when they have been in business together for years. But if the partners approach their separation in an effort to secure a win-win outcome, they can achieve a productive transition and avoid personal animosity that could negatively impact the business. These creative exits include a variety of potential structures such as phased buyouts based on future performance, asset-based divisions, and longer-term buyouts. These approaches share the common goals of preserving the value of the company and achieving a reasonable exit price that is acceptable to both partners.

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Success is not just an elusive goal – it can also be difficult to maintain once achieved.  For majority owners in private companies, achieving success is just the first hurdle, because once they arrive at this pinnacle, they may soon face a new challenge. Some of their key employees may want a piece of the pie and push for an ownership stake in the company. The dilemma for business owners when their employees are clamoring for ownership is that by issuing equity to employees, this dilutes the company’s stock and also provides employees with legal rights they can enforce against the majority owner. 

There is no single answer that meets the needs of majority owners and employees in all situations, but owners who want to incentivize their employees through the use of equity should consider all available options. This includes the potential for owners to provide their employees with “phantom equity” or stock appreciation rights rather than actual ownership (equity) in the company. This approach may help thread the needle effectively for all parties.  

Section 1: The Distinctions Between Equity and Phantom Stock

As a starting point, there are important differences between actual equity ownership in a company and phantom equity. Employees who receive stock (corporations) or units (LLCs) in their company have actual ownership, which generally provides them with an array of legal rights. These rights are subject to modification, but equity holders are typically permitted to vote on some issues, to obtain access to the company’s financial records, and to bring claims against the company’s management for violations of their fiduciary duties. 

By contrast, employees who receive phantom stock (also called synthetic equity or stock appreciation rights (SARs)) enter into an agreement that provides them with contract rights but not actual ownership in the company. For example, under a phantom equity award, the employee may receive a guaranteed payment if the company’s profits or revenues increase by a specific percentage, if the company is sold, or if the company’s value increases during a specific period in time. 

Section 2: The Majority Owner’s Perspective on Equity and Phantom Stock

From the majority owner’s perspective, there are both pros and cons to granting equity ownership that may make the phantom equity approach more desirable in efforts to incentive employees.

            The Pros of Granting Equity Ownership

One of the most important benefits of issuing equity to employees is that once they become part owners of the business, their financial interests are more directly aligned with the majority owner. The employees are now officially on the team, and this connection assists with succession planning, it helps secure long-term retention of employees, and it allows for employees to view the business on a longer-term basis. Employees will appreciate that their shares may become much more valuable over time and in any future sale or merger of the business, the sale of their shares will provide a handsome financial return and at a lower tax rate than is applied to capital gains.

            The Cons of Equity Ownership

Company owners who issue equity to their employees may come to rue that decision if the employees later become disruptive in their approach to the business or hostile to the owner.  As noted above, issuing equity to employees will dilute the percentage of shares available to the owner. Further, employees holding equity are generally entitled to access the company’s financial records, to call shareholder meetings and to bring up issues for discussion at shareholders meetings. In addition, company owners are virtually always part of the senior management team, and they can be subject to claims by employees holding equity who contend that the majority owner breached fiduciary duties owed to the company.

Finally, and importantly, if the employee later resigns or is fired, that does not extinguish his or her equity in the company, and the former employee retains all the same rights of shareholders or members. The company should have a buy-sell agreement in place with the employee that allows for the majority owner to repurchase the former employee’s shares, but this buyout process may become protracted and contentious, which creates a major distraction for the owner who wants to remain focused on the business.

            The Pros of Granting Phantom Stock Rights

There are a number of benefits for the owner in issuing phantom stock rather than actual equity. First, the rights granted in the contract are specific, and the employee can easily calculate the payment that will be made if the revenue or profit targets in the contract are achieved, which has a strong incentivizing impact. Second, the employee receives only those rights set forth in the contract, which will not provide access to financial records, the right to vote on company business or the right to bring claims against the company or the majority owner other than for breach of the contract itself. Third, in most of these agreements, the employee needs to remain employed to receive the rights granted, and as a result, the termination of employment eliminates all further rights. Thus, there is no need to go through a buy-back procedure to reacquire equity. 

            The Cons of Granting Phantom Stock Rights

There are no major cons to the phantom equity approach for the majority owner, but it may not satisfy the employee who truly wants to have an ownership stake in the business. In addition, the employee may be reluctant to accept this type of contract arrangement and accept the risk of being fired before any of the financial benefits have been realized. The majority owner may therefore need to provide some assurances to the employee such as agreeing that the payment will be made if the targets are met even in the event the employee is terminated or agreeing that the employee can only be terminated for cause during the period that the phantom stock agreement is in place.

Section 3: The Employee’s Perspective – Pros and Cons

The Pros of Equity Ownership for Employees

For employees, receiving actual equity in the business affords them the status of being co-owners in the business, which provides both financial and psychological benefits. When the employee also holds ownership in the company, the interests of the company and the employee are more aligned. Employees who are also stakeholders recognize that they are benefitting from the growing value of the business, and they also have some opportunity to participate in major decisions by the company. When they do cash out of their investment through some type of liquidity event, the employees will receive favorable tax treatment paying capital gains on the increased value of their equity stake. 

The Cons of Equity Ownership for Employees

On the downside, employees who want equity may have to “pay to play” and spend a considerable amount to purchase the equity they receive in the business. While the upside is that the value of their equity in the company may increase significantly over time, their shares or units are typically illiquid and, as a result, they cannot monetize this value until a major event takes place, such as a sale or merger of the business. Further, growing private companies often do not issue dividends or distributions on a current basis. The net effect is that the employees who have equity in the business may have to wait many years before they receive a financial benefit from their ownership interest in the company. 

The Pros of Phantom Stock for Employees

In contrast with the ownership of actual equity, phantom stock provides employees with a contract that offers more certainty about current payments. While private companies often do not issue distributions to owners, the point of phantom stock is to provide payments to employees when they help the company achieve financial milestones. When those financial targets are met, the employee is assured of receiving a payment based on the formula set forth in the phantom stock agreement. In short, phantom stock provides guaranteed payments to employees when the financial targets are achieved — there is a direct performance and award connection.

The Cons of Phantom Stock for Employees

There are three disadvantages to phantom stock compared to equity ownership. The first is that unless the phantom stock contract provides the employee with some protection, the rights that are granted to the employee in the contract are immediately extinguished when the employee is fired. This is obviously an important negotiating point for the employee to secure protection from a last-minute firing that pulls the rug out before a payment is required to be made to the employee under the contract. 

The second disadvantage is that the payments made to the employee under the phantom stock contract are typically taxed as ordinary income rather than capital gains. The upside here, however, is that the payments are made under the phantom equity contract on a current basis and the employee does not have to wait for years for a liquidity event to take place that will monetize the value of the employee’s shares or units in the the company.

The final disadvantage to phantom stock awards is that they do not provide the employee with the rights of an equity holder. Specifically, the employee holding phantom stock does not have the right to (i) attend owner meetings, (ii) obtain access to the company’s financial records, and (iii) bring claims against the company’s management for breach of fiduciary duties.

Conclusion

Majority owners who want to incentivize their employees in growing the business should carefully consider whether issuing equity to the employees is the best option. Granting equity to employees will dilute the company’s stock and also provide the employees with legal rights they may wield against the owner – a case of biting the hand that fed them. But owners who choose to grant phantom equity to employees will avoid both these downsides while also providing the employees with potentially robust financial incentives.

Employees may also agree that phantom equity, despite the name, will provide them with significant financial benefits they receive on a current basis. Further, the owner can use the phantom equity program as a testing ground to see if it provides a win-win for both owners and employees over some period of time. If the phantom equity approach is successful, there are increasing instances of owners who are adopting hybrid plans where phantom equity is converted to actual equity upon triggering events such as achieving certain valuation thresholds, securing certain amounts of financing, or successfully launching an IPO. This hybrid approach may open the door for the owner as part of a succession plan for the business. 

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During Valentine’s Day month, we are taking a look at 50-50 owned private businesses.  Forming a co-owned company may sound like a good idea on paper because the two partners are close friends or family members who are making the same investment, sharing equal control, and receiving the same financial returns. But, as in marriages, the co-owners may run into conflicts they cannot resolve, which could require a costly business divorce. This is the chief problem with these co-owned businesses: When conflicts arise the partners cannot work out, they will be in a position of deadlock that distracts or ultimately derails their business.   

The Deadlock Dilemma Is the Real Deal

The risk of a co-owned business capsizing over unresolved conflicts between the owners is substantial and many of these companies come apart because the partners failed to create any type of dispute resolution process. Here are two examples: first, the ubiquitous Buffalo, New York, law firm of Cellino & Barnes, broke up in 2020 after 25 years, but only after the partners engaged in a highly publicized, three-year-long legal battle resulting in a court-ordered buyout. The litigation between the two law partners was so contentious it led to an off-Broadway play produced about the case. The second example is the lengthy legal battle between the co-CEOs of TransPerfect Global, Inc., the translation services company, which the parties finally settled in 2020 after six years of litigation. 

In light of the high risk of conflicts arising in the future between the co-owners of these businesses, the two partners should consider whether this ownership structure is truly their best option. If they do decide to go down this road, however, the good news is that they have some options to consider.  This post reviews specific, practical steps the co-owners can take to head off problems that might otherwise cause their partnership to end in a bitter feud.

Another Approach: Shared Financial Returns, But Not Equal Co-Ownership

One approach for the partners to consider that will avoid future conflicts is to adopt an ownership structure that provides financial equality, but with a modified ownership percentage. Under this approach, the partners would agree to an ownership percentage of 51% to 49%, but also agree in the company’s governing documents to share equally in the company’s profits and losses, as well as in the amount of their compensation. This structure provides for both partners to share the same financial results from the company’s performance, but it establishes a process for decision-making by the company that will not result in gridlock.  

Further, the majority owner will have the right to make operating decisions on a day-to-day basis for business, but the minority partner will also have veto rights over some of the most important decisions, and these will be subject to negotiation. By way of example, the partners may decide that a unanimous vote of both of the partners will be required to admit new partners, to approve the sale of the business, and/or to permit the company to take on debt above a certain amount. This structure thus avoids conflicts over most of the decisions that need to be made to keep the business moving forward. 

Create a Set of Clear Tie Breakers

For partners who are insistent on having equal ownership in the company, it is critical for them to adopt a tie-breaking mechanism that will prevent them from reaching the point of deadlock over future business decisions. Some of the tie-breaking options available to the partners are reviewed below. 

  • Zones of Authority

For certain companies, the roles of the two partners will be distinct, and in those businesses, the partners may be able to agree that each partner will have the authority to make decisions in their own domain. For example, a partner in charge of marketing and business development may be given authority to decide on what the website will look like, who to hire/fire in the marketing/sales department, and what marketing strategy to adopt. Similarly, a partner running the company’s back office may have the authority to select the accounting software and the CPA firm the company uses, to set pricing on products or services, and to hire a CFO or comptroller. 

The problem with this approach is that the partners will have to agree on some decisions that do not fall into these clear categories and they may have conflicts deciding other issues, such as the amount of the company’s expenses, profits distributions, acceptable debt level and growth rate. The bottom line here is that there will still be many common areas in which a potential deadlock may arise between the partners. 

  • Create a Neutral, Tie-Breaking Authority

The obvious tiebreaker is for the partners to agree to appoint either one person or a small committee or board (usually three people) who have some industry or other experience and who will make decisions to resolve all conflicts between the partners. While this approach sounds reasonable, it may be difficult for the partners to agree on the selection of one person or of a board of three people to serve in this capacity for the company. 

In addition, even if the partners can agree on the specific person or people they wish to appoint, these individuals may not be willing to take on this role knowing that, at some future point, they will disappoint one of the partners by making a final decision that rejects the other partner’s position. To persuade anyone to serve in the capacity of a tiebreaker, the partners will also, at a minimum, have to agree to fully indemnify the people who agree to serve in this role. The partners will also have to agree to pay the legal fees for any and all disputes incurred by the tiebreakers in which they become involved because they agreed to serve in this role.  

  • Adopt an Arbitration Procedure

For more complex disputes, the partners could agree to arbitrate these conflicts on a fast-track basis that resolves the dispute in 60-90 days. This is a much more formal approach to conflict resolution as it would involve using a private arbitration service, but the process will result in a clear, final and non-appealable result.

Further, before the parties agree to participate in arbitration, they could require that a mandatory, in-person mediation be held before any arbitration is filed. This would requires the parties to engage in one last mediated settlement conference in efforts to reach a resolution before they start any sort of legal process.

Enter Into a Negotiated Buy-Sell Agreement

Even when the partners do appoint an individual or board to resolve any conflicts that arise between them in the future, that may not end their discord. The partner whose position was rejected by the individual or board may be frustrated by the outcome, have hard feelings toward the other partner, and/or be concerned the company is now going off track. In this situation, the partners need to have a buy-sell agreement in place that provides a clear process for the exit of a partner to take place. If there is no off ramp for a disgruntled partner, things may go downhill rapidly in the business, because this unhappy partner may decide to create disruption (or worse) in the business in order to pressure the other partner to buy out that partner’s interest. These types of legal disputes between co-owners involving claims for breach of fiduciary duties can create significant distractions and substantial expense for the partners and the business. 

The buy-sell agreement between the partners needs to address all of the following issues: (1) what are the circumstances under which the buy-out can be triggered (who can trigger it and how is it triggered); (2) what is the process for determining the value that will be paid for the departing partner’s ownership interest in the business at the time of exit; (3) what specific terms apply to the buyout payment (how many years, what interest rate and what collateral will be provided in the event of a default); and (4) what is the dispute resolution process for resolving any conflicts that arise regarding the application of the buy-sell agreement. 

A critical part of this buy-sell agreement will be the process for deciding who is the buyer and who is the seller. This is often termed a “shotgun” provision, and it operates by allowing one person to make an offer to purchase the interest of the other partner, then the recipient will have the option to accept the purchase offer or to reject it and then become the buyer.

How this provision will work in practice therefore needs careful consideration to ensure that the business goals of the parties will be achieved if the clause is triggered in the future. 

Conclusion

Starting a 50-50 owned business is exciting, but it is also inherently risky because it almost certainly requires the close collaboration of both of the partners on a long-term basis for the business to be successful. When the partners have serious disagreements, that can lead to a deadlock that cripples the business because key decisions will be postponed, investments will not be made, and opportunities will be missed. Also, the lack of clear direction when the two partners are locked in an impasse is likely to have a negative impact on both the company’s employees and customers. 

If the two partners remain willing to accept these risks of entering into a co-owned business, they will want to do so with vigilance to head off future conflicts as much as possible. This planning process will require them to implement a tie-breaking process designed to resolve future disputes, as well as to negotiate and enter into a buy-sell agreement that enables them to achieve a business divorce if they reach a point where irreconcilable differences exist between them.

For both partners to keep smiling on Valentine’s Day and beyond, these planning measures will give them and the business the best chance to prosper on a long-term basis, and it will also provide a plan for a partner exit to help avoid a bitter, protracted business divorce down the road.