Forming a business entity with partners for real estate or other purposes requires careful thought. There are many factors to consider. We have written about some of the important considerations before (see prior posts HERE and HERE). One consideration that deserves particular attention is the exit strategy if the business doesn’t go as planned or, more specifically, if one partner doesn’t perform as expected. This is extremely important for the money partner where the minority or sweat partner is given equity up front without making a cash contribution or with only a small cash contribution or has options to acquire equity for little to no investment other than “sweat”.
Two years ago, I drafted such an Operating Agreement for a client. My client, the money partner, who would also be taking an active role in the company. The client was funding 100% of the initial cash needs of the company. As such, he would receive 99% of the membership interests in the newly formed LLC. The minority partner was to provide only sweat for a 1% stake. We treated the client’s investment as a loan. The minority partner had an option to receive up to 49% of the interest in the company if he made a $100,000 contribution to the company in the first 2 years. That contribution would be used to pay down the client’s loan. Upon making the contribution, the client would immediately transfer 10% of his shares to the minority partner. If the partner did not make the contribution on time, the option to acquire a larger share of the company was reduced to 30% and either way, transfers of membership interests to the minority shareholder would occur going forward only when the company was able to generate sufficient revenue to pay down the debt owed to the client. Transfers would occur at certain benchmarks.
The partner did not make the capital contribution and the company was unable to generate revenue so the loan was not repaid at all. Instead, the client made additional loans to the company. The client recently decided that he wanted a way to change the deal. Fortunately, we planned for that. We added provision to the Operating Agreement allowing the client, as the manager, to terminate the minority partner’s employment with the company without cause. Upon such termination, the company was obligated to buyout the partner at an agreed price of 150% of the value of the partner’s interest in the company. The company value would be determined by the company’s accountant.
This provision is very clear and the partner had a decision to make. He either had to renegotiate the option provision, which the client felt was necessary in order to attract new investors to the company. Or, the partner could allow the termination provision to kick in. That would, in effect force the partner to pay his share of the company debt to the client because the company debt is currently greater than its assets.
Planning for the worst can help to avoid protracted disagreements. While the partner, in this case, was initially uncooperative, after further thought and conversation, the parties did, in fact, come to a satisfactory conclusion. The client’s position was protected and he will be able to attract new investors to the company in the future and hopefully, grow the company and recover his investment.