Including a Buy/Sell Provision in Multi-Party Business Ventures

Remember the old maxim, failing to plan is planning to fail. In an attempt to plan against failure, the majority of business owners get tunnel vision and end up planning exclusively for success, neglecting to recognize the periphery known to the veteran entrepreneur as the unexpected. In light of this, I’ve prepared this segment to briefly address the benefits of including a buy/sell provision in any business partnership.

When a closely held joint venture entity (i.e., a privately owned business) is formed for a business deal, whether it be active business sales or real estate development, the parties will generally choose a corporation (“Corp”) or Limited Liability Company (“LLC”). These forms of entities provide great flexibility for crafting exit plans as well as complex capital structures and governance arrangements.

Exit plan? Yes… you read correctly. Why would you ever physically enter a place without any idea about how you would exit. Same goes with entering into a business venture with others.

Initially, when business partners engage in a venture, it’s like running into a newly married couple–only happy thoughts. What the blissful partners fail to plan for, is the prospect of failing. Hence, the need for an exit plan. Of course, with marriage, a prenuptial is viewed as one-sided, fortunately in business, an exit plan is good measure for all parties involved.

Let’s assume a simple model of a two-party, single-asset real estate venture, or as I would like to call it–a flip. One of the parties is the “developer,” Mr. Handy, and the other is the “financial partner,” Mr. Dough. With a briefcase full of cash, they find a sweet fixer-upper, close the deal, place it in the name of their entity, and begin development.

It is not uncommon that these types of ventures follow a “major decisions” model in which Mr. Handy will be the party who will “run the project,” and all “major decisions” will require either mutual approval or may be dictated unilaterally by Mr. Dough. Of course, the parties’ choices in designing the decision making of the Corp or the LLC will set the stage for each party’s need for an exit strategy.

To continue, let’s assume there is a falling out between Mr. Handy and Mr. Dough, or better yet there is a deadlock on how to proceed with the project due to unforeseen circumstances. Because Mr. Handy and Mr. Dough are locked into the venture, when conflicts like these arise, the entire investment is in jeopardy. This is an especially concerning issue because many parties form entities which include internal governing documents with default provisions that effectively require mutual approvals.

As a practical matter, when an issue arises that can only be resolved by mutual approval, the result is a continuous cycle of disagreement–for those of you who are married, I’m sure you can relate. Inability to agree will produce a deadlock. In light of this, the future of the project will be at stake. If there is neither a deadlock resolution plan nor exit plan such as a method for disposing of the project or a buy-sell agreement, Mr. Handy and Mr. Dough are forced to apply for a court-ordered dissolution. A court-ordered dissolution is not the way to dispose of business assets at the best price. If there is a deadlock, the ability of the participants to sell their interests to third parties is not very useful (i.e., anyone willing to buy into a bad situation is probably expecting a bargain and will not pay fair market price).

Moreover, there are many other considerations that need to be made in the event that one of the parties falls ill, files for bankruptcy, dies, or has a divorce. It may be news to you but California is a community property state, consequently, in the event your partner dies or has a divorce, his spouse may end up owning half or more of his interest in the venture–stepping into your partner’s shoes and having an influence in business decisions. You want to plan for these unfortunate situations, and with a buy/sell provision in place you will have a right of purchasing the shares/interest at a predetermined price upon specified events like death, divorce, and even bankruptcy. It should also be noted that as an S-Corporation, there are certain shareholder requirements to qualify for and maintain the preferable S-corp tax status (i.e., avoid double taxation); thus, transfer restrictions of share certificates to members who would not qualify must also be considered.

Thus, it is through a buy/sell agreement that both parties can prevent a financial catastrophe. Remember, failing to plan is planning to fail.