Archive for the ‘Exit Strategies’ Category
01/4/2010 | 7:30AM
Business partnerships are one of the most unique and trying relationships we will ever enter. Some work, but most fail. I did a quick test. I searched Google for “business partner problems” and found about 169 million results. Compared to only 143 million results for what I assumed would be the more common term of “business partner,” I think it is clear that many struggle to make these arrangements work. Here are four warning signs that our relationship with our business partner(s) may be headed for failure. Please note that this article assumes that business partnerships are in the common form of a Limited Liability Company (LLC).
1. No Operating Agreement - many states do not require an LLC to have an operating agreement, and, therefore, many business owners and entrepreneurs do not understand the importance of this legal document. The operating agreement is the agreement between all of the owners, or members, on how the business will run, who will be in charge, and so much more. Let me share one brief example to portray the need for an operating agreement.
While at a social event recently with my wife, we connected with one of her friends from college. He has started a business and his product is starting to sell and pick up some nice momentum. He spoke for quite some time about how excited he was, how much fun he was having, and his new-found joy in finally pursuing his passion. I asked if anyone else was involved with the business, and he said he had two partners. The entire tone of the conversation changed as he described how his “partnership” had evolved, or perhaps a better description would be disintegrated. It started with three friends getting excited about an idea. They decided to split everything three ways and they failed to put anything into writing (namely, an operating agreement). As time passed the expectations, time commitments, investment, and basically everything else related to these “equal” partners fell completely out of balance. Arguments replaced friendship and greed supplanted a desire to share everything equally. The problem – they never created an operating agreement that defined all of the important legal, financial, management, and time issues for their business. The lack of an operating agreement has sent this budding partnership into a death spiral that will likely end in a painful and expensive divorce.
Please know that I have many more examples like this than I do of successful partnerships. One thing all of the successful partnerships have in common – they have an operating agreement. While certain online resources can help entrepreneurs organize their entities legally, special care and consideration should be paid to the operating agreement. It is very wise to seek appropriate legal counsel as well as have healthy and lengthy discussions with your partners before you finalize this agreement.
2. Partner Pride -This is something that usually shows up when a partnership begins to have struggles and accelerates its demise. Here is one real-world example of partner pride. Two men started a business, each owned about 45%. The remaining 10% went to other key employees. As the business grew and became quite successful, one of the 45% owners took great pride in the success of the company. He began to tell his family and close friends that it was his company and that he was the major contributor to its success. His pride allowed him to minimize his main partner and falsely establish himself as something he was not. When this partnership began to fall apart and his partner extended a very fair offer to buy him out, he refused. Why? In his mind, he could not communicate to all of his family and friends that the business could exist after he left. He was so infatuated with his fictitious position that he could not make reasonable or logical decisions. The matter was finally resolved, but not without great distractions and damage to the business.
The best way I have seen to keep pride out of a partnership is to regularly review the contributions of all involved as well as discuss how each partner can improve. If done correctly, this serves to keep everyone grounded and grateful for each other.
3. Compensation and equity are confused -Let me be as straight-forward as I can with this topic. Too often I see entrepreneurs, founders, and business owners that confuse equity and pay/compensation. These two items must be separated in order to set your partnership up for success. A few years ago I was introduced to a business with 50/50 partners. 12 months earlier one of the partners had become permanently disabled and unable to further participate in the business. The partner remaining in the business was frustrated that the other partner put zero time into the business yet was still getting 50% of everything the remaining partner generated. This partnership was about to fall apart until we set a fair and reasonable wage for the partner still working in the business. The other partner’s wage was reduced to zero since he was not working in the business, although he was still entitled to 50% of the profits based on his ownership stake in the business. Problem solved.
Ownership does not mean you should receive a wage or guaranteed payment. Ownership means you participate in profits after all expenses are paid, including the wages of those working in the business. In the spirit of understanding the difference between equity and pay, each partner’s compensation should be reviewed at least annually. In this scenario, it would not be uncommon for one partner to receive a higher salary than another, especially if there is a difference in the amount of time put into the business. Please note that the legal and tax structure of the business may determine the best ways to receive both wages and profits, but that should not dictate the separation, at least mentally and emotionally, of the two.
4. Beginning without the end in mind -perhaps all of these points lead to this one – the need to contemplate every way the partnership will need to end or be dissolved. Here is just a brief list of the different life events that could impact a partnership: death, disability, lack of interest, relocation, new opportunities, family changes, and more. How will each of these situations be handled by the partnership? An operating agreement and potentially a buy/sell agreement should contemplate these events.
In addition, beginning with the end in mind implies that a partnership will have planned exits as well. Selling a business can be very rewarding, and a partnership needs to look down the road to how each of the partners will exit. For example, one partnership for which I serve as the part-time CFO consists of three partners under forty and the fourth partner is almost 65. The younger three want to stay in the business for a long time while the older partner is hoping to exit the business and retire in a few years. Orchestrating this partner’s exit while not hurting the business from a cash flow and leadership perspective take thought, consideration, and planning.
The point is this – if a partnership does not properly plan for expected and unexpected exits, it will likely fail.
Do any of you have good or bad partnership experiences to share?
10/26/2009 | 12:00PM
The following is a real situation with names and details altered for anonymity.
The business is struggling and the owner, who is not actively involved in the day-to-day management of the business, wants to get out of the business. He would like to sell the business, but valuations have come down and he wonders if he can get more cash from just closing the business and pocketing whatever cash is left.
Although some of the employees have interest in buying the business, the main issue (as it is in many buy/sell transactions) is the price they will pay. And this is where this scenario raises an interesting point.
The business is in an industry that has been very negatively impacted by our current recession. Within the next two months the company will have completed all of its work-in-progress and backlog, meaning there will be no more work for the company to perform after 60 days unless the company can secure new work in that time frame. The market for their work and product remains weak and may continue to be weak for the next 12 months or more.
The book value of the company is about $1,000,000, meaning when all liabilities are subtracted from all of the assets of the firm, the remaining value is about a million dollars. The EBITDA valuation method generates a value between $700,000 and $1,500,000 depending on which multiple is used. The Discounted Cash Flow (DCF) valuation comes in between $500,000 and $1,500,000 depending on the cash flows projected and the discount rate assigned to the model. It is interesting that some of the valuation models give ranges that fall below the current book value of the firm. This is likely a result of the struggles the company has suffered recently and that are projected into the coming years.
So, what is this business really worth to the employees? Instead of looking at these valuation scenarios, most of the employees are interested in buying the business so that they can keep their jobs. When faced with the prospects of the company closing down in a few months and their impending unemployment, the employees would rather try and come up with the cash and capital to buy the business and keep the business alive. Certainly their investment and continued employment are now at risk (because their savings/investment) was not at risk before, but they seem to be willing to take such a risk. Why?
The only logical reason would be that they feel that the business has some intrinsic value at or greater that the purchase price. Perhaps they have insights into the market and their prospects for more work. In this situation, the real reason is because unemployment is so high in this industry that these employees know they will most likely be employed for a long time. In fact, they are pretty confident it will take so long to find a job that they would burn through some, if not all, of their savings anyway.
This is a good company that has built a good reputation in the market among its customers, competitors, vendors, suppliers, and others. The company is also positioned well competitively and will continue to make the most of its opportunities because the management team is strong, knowledgeable, and experienced. The employees trust management, and management will represent the majority purchasing stake.
In this scenario, the employees are the best possible buyer for the business. There are no formal or sophisticated buyers in the market for this type of business and any other potential suitor would be interested in a fire-sale price, at best. And, after a buyout like that, most of the employees would likely lose their jobs, anyway. The seller can get the most value for the business as well as a comfort that the business can continue on while the buyers can retain their employment and potentially improve the earning potential of their investment into the business.
As one caveat, it would certainly be advisable for each of the employees to consider their overall diversification strategy for their assets. With capital invested into this business as well as the business being their primary, if not sole, source of income, it may begin to look like all of their eggs are in the same basket. Each employee should talk to their financial planner or advisor for further consideration.
07/28/2009 | 9:00AM
Here is a real situation that has a partnership of four up-in-arms:
Each partner owns 25% of the business. Three of the four partners have stellar credit and decent net worth. The fourth partner had a bankruptcy 4 years ago and does not have much net worth, other than the value of the business, to speak of.
The company has a customer present an opportunity to them to double their business in 12 months. The catch – they will need to buy over $1,000,000 of equipment to capitalize on the lucrative opportunity. Even though the credit markets are tough, this company is able to secure the financing it needs under one condition – the three partners with good credit have to guarantee the loans, but the fourth partner cannot.
The three partners have exposed themselves to more risk than the fourth. So, is the partnership still actually equal? Not in terms of risk.
In this scenario, the three partners are fine to expose themselves to this additional risk to give the company a chance to grow. They do wonder, however, if they should in some way receive compensation for taking on more risk than the fourth partner. If for some reason the company defaults on the loans, then the three who signed personal guarantees will have to resolve the issue eventually with the creditors. The fourth partner gets to walk away without these issues.
I have seen some interesting ways to handle this issue, and I would welcome additional feedback on how to best handle this. Any and all ideas are welcome.
One last thought – if anyone is considering taking on one or more partners in their business, this is an issue that should be considered and can even get in the way of financing your business. If your partner owns at least 20% of the company, some lending institutions will require that they run a credit check on them – and if their credit is bad, the lender will probably decline the loan!
ADDITIONAL COMMENTS
I received some great feedback on a social network for startup CFOs that I wanted to add.
Mark McLeod says:
Interesting situation Ken. You could approach this a few ways:
1.) Risk adjusted return on the leverage the 3 partners are taking on: some additional premium either as a % of the loan or non equal distribution of profits from the incremental business
2.) Separating the legacy and new business on paper and again having non-equal profit split on the new piece.
3.) Re-evaluating whether this 4th partner is necessary for the future of the business. Will he drag them down or can he be an equal and full contributor?
Peter Towle says:
Another option to explore IF the other partners want to keep the ‘bad-credit’ partner in as an equal profit participant (or try to keep it equitable) is to create a side agreement between the partners that encumbers the ‘bad-credit’ partners assets, future assets, or share of the business should there be a problem.
Richard Wong says:
Some good answers from Mark and Peter, I would also add the possibility of another:
Since this new business will result in a major change in the net assets of the company and I am under the assumption the partners like working with each other and that’s the reasons they’re still partners that they revise the partnership agreement to show the new partnership percentage based on this, otherwise it may be time to incorporate.
They have a holding company, where 3 of the 4 are given a larger %ge of the shares, a subsidiary (the main operating co.) and then based on some measure ie. net profits of the added customer business dividends could be given to the 3 shareholders who took the credit risk, until the loan is repaid, then based on some sort of gentleman’s agreement that the 4th partner earn his way to an equal shareholder percentage.
Now the above could all be thrown out the window if say the 4th partner is the one who brought in the customer and negotiated the extra business because let’s say he’s a better salesperson than the other 3?
Hope you can facilitate a paper solution to this Ken.
Great feedback so far…I’m open to more ideas, thoughts, and suggestions!
If a CFO partnership faced the same challenge, how would each CFO partner resolve this same issue?
01/19/2009 | 2:29PM
If you want to sell your business, seller-financing has become an even more common requirement. First of all, seller-financing is common and there are many resources on the Internet that explain the risks and rewards associated with such a practice.
The credit crunch appears to be making seller-financing even more common, although I have yet to see statistics to back that up. It is no secret that the commercial loan market has slowed dramatically, and the number of SBA loans have dropped as well. This has not provided any financial help for small business. Private equity firms are acting much more conservatively, mainly because they employ a strategy of maximal leverage when they buy small companies with high growth potential. The debt financing is not as available as it used to be, and they are not willing to tie up more of their investors’ funds in these high risk enterprises. These and other factors mean a motivated seller needs to be more ready than ever to finance at least a portion of the price of the transaction. This is a reality of the current market in which we operate.
12/30/2008 | 6:21PM
Discounted Cash Flow? But what multiple or discount rate should we use? Inc.com wrote about a new website aimed at removing some of the mystery from this age-old question. The topic of the article is a company called You Noodle, Inc, and their website. They offer a Start-Up Predictor that guesses the value of your start-up three years into the future. I took the test and got a valuation much higher than I expected. I think they still have a few kinks to work out of their system, but this is a concept worth watching.
I have been through many professional valuations where experts come in and use a variety of formulas and other subjective and objective factors to determine the value of the company. The reality is that the business is worth what someone else is willing to pay for it. Entrepreneurs and business owners should never waste their time trying to figure out the details of business valuation. They need to focus on adding value to their businesses in the form of creating systems, processes, and procedures that create satisfied customers and reduce the labor and material inputs into the business to their lowest and most efficient forms. If you are having difficulty understanding the value of your company, please feel free to contact on of our CFO Advisors.
