Volume 8, Issue 17, November 4, 2021

I have recently encountered a few situations where partners in a business do not agree on the current plan for the company, with one partner(s) is ready to sell while the other(s) is not. This is often a situation unanticipated by entrepreneurs when they decide to become partners in a business. This is not surprising. After all, the focus at the time of the partnership is usually the start of the business rather than its potential or eventual conclusion. Thus, there is rarely a conversation about the end game — the exit when one or all owners are ready to retire or move on to the next start of their career.

A business partnership where owners have equal stake in the company can lead to a plethora of problems from disagreements in operations to exit strategies. Whether you're just starting out or already functioning as a super team, it's never too early to discuss the "what ifs" for future decisions. But wait too long and it can't be too late!

Mike Gillette is a friend, colleague, and a lawyer and shareholder at Polsinelli (mgillette@polsinelli.com) who has helped many of my sellers transact. I asked him to share some insight from a legal perspective into how co-owners of a business should address issues that develop around disagreement about the future for the company. The following section summarizes his thoughts.

Partnership Problems: A Legal Take

When potential issues with partners disagreeing on a sell decision arise, a good first step to take is to a look at the company's organizational or governing documents (e.g., an operating agreement or shareholder agreement) to determine how the entity is managed and governed, and how, if at all, disputes or disagreements among the partners relative to business or selling decisions are addressed.  

In a situation where one partner(s) is in the majority and the other(s) are in the minority position, the majority owner(s) can sometimes unilaterally authorize a transaction under a  structure where that the company itself is the party to the transaction — e.g., an asset sale or a merger. This can depend upon the scope of the majority's governing authority and any minority approval rights in favor of the other partners.

But even with strong majority governing rights, there could sometimes be issues in structuring a transaction that requires the minority partners to be parties to the transaction documents — e.g., an equity purchase transaction where the partners are the parties doing the selling.

Likewise, there could be issues where the ownership or governance is divided equally between partners who disagree on the path forward — e.g., a 50/50 ownership structure where the partners co-manage or comprise the entire board of directors, such that a deadlock is possible.

Partners often plan for these situations in advance by incorporating certain provisions in their organizational or governing documents. These can include the following:

• Rights of First Refusal (ROFR) or Right of First Offer (ROFO). Where there is a right of right of first refusal, a partner who wishes to sell can go out to the market to find a buyer for their interest, and if they are successful in locating one, they are required to present that third party offer to their partner so they can take it (typically on the same terms), if the other partner declines to exercise the right, the first partner will be free to sell their interest to the third party on those terms for a period of time. A right of first offer is similar but works in the opposite way, the partner who wishes to sell is required to give their partner the first opportunity to make an offer for their interest.  Typically, the first partner can decline the offer and go to market to find a third party buyer, but if they accept an alternate offer from a third party it has to be at a price higher than the other partner offered at the prior step, and the closing must occur within a certain period of time.

• Co-sale or tag-along rights. Often coupled with a ROFR or a ROFO, this gives the other partner the opportunity to decline the ROFR (or lose out to a third party bidder through the ROFO) and instead require the selling partner to include their interest in the sale to the third party that the selling partner has identified.

• Drag-along clauses. This provides a mechanism where a partner can compel a dissenting partner to go along with and participate in a transaction (i.e., be "dragged-along").

• Purchase options. This provides a mechanism where a partner can compel a dissenting partner to sell their interest to the partner who wants to sell or, alternatively, compel the partner who does not want to sell to buy out the one that does. The provision requires addressing key issues of (i) what triggers the option, (ii) how the interests are valued, and (iii) closing mechanics and how payment is made.

• Put-call or shotgun clauses. This provides a mechanism whereby one partner can put out a valuation to the other partner and the receiving partner needs to choose between (i) selling out to the first partner at that valuation or (ii) buying out the first partner at that valuation. One of the virtues of the clause is that the first partner does not know if their will wind up being a buyer or a seller. Thus, they are incentivized to pick a value where they would be happy either way, which in turn is a good analog for fair market value. While valuation is discovered through the mechanics of the procedure, you must still need to address issues of when the clause can be invoked and closing mechanics/how payment is made.

Partnership Problems: The M&A Take

I hope you found Mike's thoughts helpful. I'd like to share a few of my own from my perspective as a merger and acquisition (M&A) advisor.

Have a straightforward discussion with your partner at the beginning of your partnership or when things are going well. Outline some of the worst-case scenarios for your company, such as the loss of a partner, a desire to exit, or a difference of opinion around a significant issue, like the direction of the company or investing in growth opportunities. Engage an advisor like a lawyer or consultant who can help document how individual issues will be handled in an equitable way. Plan your exit strategy for the day when at least one of you wants to leave the company and come to agreement on terms and valuation methods. In other words, make a plan!

Although most of us never consider the idea of a prenuptial when we are getting married because it was "all about the love," statistically, about half of us would be much better off if we had. Fortunately, this subject is much easier broached in a business relationship since most people agree that business should be treated professionally and with an abundance of planning. It's important to sit down with your partner and discuss the difficult stuff while it's still just a concept and not a reality.

Michael Gillette is a partner in Polsinelli’s Phoenix office and a deal lawyer who brings a common sense and practical approach to negotiating and closing complex commercial transactions. Michael’s practice primarily centers on the representation of emerging and established companies, investors, and entrepreneurs across a range of industries, where he serves as a trusted advisor on general corporate and transaction-specific matters. He can be reached at mgillette@polsinelli.com or +1 602.650.2307.