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Business Breakups

Written by: Patrick C. Closson

(Article originally published in the New Hampshire Business Review, July 18, 2008. http://www.nhbr.com/apps/pbcs.dll/article?AID=/20080718/INDUSTRY04/475532337)

As with any relationship, difficult financial times can put a strain on the relationship between business owners. During a tough financial period, issues that were overlooked during better financial times become sore points and can lead business owners to decide to sever their business relationship (often called a business divorce). Like marital divorces, a business breakup can become a highly emotional and difficult process for all parties involved, including owners, employees, customers and suppliers. As business owners contemplate a business breakup, there are several key issues that should be considered and evaluated before commencing the breakup and throughout the process.

Rules of the Game

Business breakups are not uncommon. Most professionals, including lawyers, accountants and other business advisors are aware of this and often recommend that their clients enter into agreements that address in advance how a business breakup will be handled. These agreements among owners (sometimes called Shareholders' Agreements or Buy/Sell Agreements) provide the owners with a roadmap for how to deal with breakups should they occur. Generally, these agreements address the process for buying the ownership interests of an owner who chooses to leave the business, how to value the business when faced with a breakup scenario, and how payments will be structured. A well drafted agreement provides all owners with a degree of certainty regarding how the situation confronting the business will be resolved. This certainty allows the acrimony among the owners to be lessened in the event of a business breakup.

Business owners who are contemplating a business breakup should also consult the charter documents of the business to determine if these documents contain any provisions that may impact how the business separation is structured (e.g., right of first offer, right of first refusal, mandatory buyout).

Key Issues in a Business Breakup

When relationships among business owners deteriorate this breakdown can result in the owners no longer trusting each another. This lack of trust often makes it difficult to "just work things out." This is made more difficult if the business owners focus on separate areas of the business and are not fully informed with respect to the operations in the other areas. This lack of information about what the other owner is doing is often filled with thoughts of conspiracy and skullduggery. In these situations, business owners may need people outside the business (e.g., trusted business consultant, attorney, accountant or legal system) to help them structure the business separation.

Where business owners are able to effectively communicate and structure a separation plan, the issues they most often struggle with are valuing the business and the method for making payment to the departing owner. With respect to valuation, there are a number of methods that can be used to determine the value of a business (e.g., asset method, income method, market data approach). In certain businesses asset value is the key indicator of value, while in others businesses cash flow is the most critical factor. It is often difficult to determine what the appropriate method is for a particular business and how to properly apply the appropriate method. For this reason, business owners facing a business breakup are often best advised to seek out assistance from a professional and business valuation firm to assist the owners. A professional business valuation firm will be able to apply and analyze multiple methods as well as review transactions in the industry to determine an appropriate value for the business.

The value assigned to the business is the area where most disputes arise among business owners in the business breakup context. Surprisingly, most business owners do not have a good sense of what the true value of their business might be. While they often have some anecdotal information about what their business might be worth, this information is generally unreliable and oftentimes is not a good reflection of the value.

Once the valuation hurdle has been overcome, the business owners can then evaluate how a buyout should work. Depending on the situation, one owner may offer to buy the other owner's ownership interest, or the owners can decide to sell the business to a third party. If the business is sold to an existing owner, the buyer will often seek financing to buy out the departing owner or structure a payout over a certain period of time (e.g., quarterly payments over a period of three years). If a payment over time is agreed to, the selling owner often requires security from the business and a personal guaranty from the buyer.

Should the owners not be able to agree on a buyout structure or method, the owners can agree to sell the business and divide up the revenue from the sale. While this scenario is relatively straightforward, depending on the economic climate and circumstances related to the operation of the business, structuring a viable transaction with a third party can prove difficult. Should a buyout and a potential sale not be viable options, the company can dissolve and liquidate its assets. A liquidation often results in the owners foregoing the maximum value for their business. That said, a liquidation is sometimes the only viable option.

Given that economic times will likely put more pressure on businesses, business owners are wise to put in place a viable plan for separation in the same way one plans for an organized distribution of personal assets by putting an estate plan in place. As with estate planning (or pre-nuptial agreements), in the event of a business breakup a well drafted plan can help business owners avoid what can become a bitter dispute.

While the issues facing separating businesses are often challenging, it is possible for business owners to separate their interests without resorting to a legal battle.

Patrick Closson is a Director in the Corporate Department of McLane, Graf, Raulerson & Middleton, Professional Association. Patrick can be reached at (603) 628-1457 or at [email protected]. The McLane Law Firm is the largest full-service law firm in the State of New Hampshire, with offices in Concord, Manchester and Portsmouth.

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