Solving the “Liquidity Problem” is One Key to a Successful Business Divorce
When you start your San Diego business with colleagues and friends, everyone hopes that the business will succeed and the friendships will last forever. Sadly, this is not always the case. For various reasons, business partners and associates grow apart and there is a need for a “business divorce.” The possibility of a business divorce is one important reason that new businesses need to agree to and prepare Owner Agreements that contain buy-sell provisions. In every business divorce, there are at least three parties — two owners/sets of owners and the business itself. It is important to navigate a successful divorce so that the business does not suffer. This helps maximize value for the remaining owners and the exiting owners. An experienced San Diego corporate attorney can offer advice and counsel on setting up your Owners Agreement and your buy-sell provisions.
One of the most difficult hurdles to a successful business divorce is the so-called “liquidity problem.” Even if the parties have agreed with respect to value, there might not be enough liquidity, cash flow, or assets to consummate the divorce. In general, a business divorce entails the sale by an owner or owners (the “Exiting Owners”) and the corresponding purchase by another owner or owners (the “Buying Owners”). Here are a few ways to manage the liquidity problem:
“Balloon-Type” Payout With Flat Payments
In general, like a balloon-type mortgage, the idea here is that the Buying Owners will make flat monthly or quarterly payments to the Exiting Owners with an expected “cash-out” payment at the end of three or four or five years. With this strategy, payments are the same each period and are not tied to revenues or profits. This is the sort of solution that must be agreed to up front. Business divorces tend to become emotional and Exiting Owners tend to demand immediate payments. Thus, a balloon-type payout is difficult to arrange at the point of separation. However, on the front end where emotions are less intense, owners can see the advantages. For the Exiting Owners, the upside to this strategy is that it maximizes the value of the business, generally leads to a higher buy-out price and often comes with interest payments (although this is not always agreed to). The extra time also allows the business to stabilize with a new configuration of ownership and may help with a financing option for the buy-out.
An important aspect of this sort of liquidity solution is to have contractual provisions requiring on-going efforts to consummate the buy-out (or find a third-party buyer). Another important aspect is to limit the involvement of the Exiting Owners in management decisions. This may involve voting restrictions and other methods of ensuring totally passive ownership. On the other side of the equation, the Exiting Owners should receive some sort of collateral in stock or inventory or other assets to ensure priority and eventual payment.
Floating Percentage Revenue Buy-Out
Here, the buy-out is based on monthly payments that are tied to revenue or profits. Payments are made at some interval — monthly, quarterly, or annually — based on some agreed-to percentage of revenue/profits until the buy-out price is paid in full. There is no expected “balloon” payment. This is a variation on royalty or revenue financing. The percentage that is agreed to is based on many factors including
- Historical sales and revenues
- Profit margins
- Expected sales and revenues post-divorce
- The desired term of months/years for the buy-out
- And more
As with a balloon-type buy-out, the Exiting Owners are generally restricted in their involvement in running the business and, often, the parties agree to some sort of collateralization.
Finding a Third-Party Buyer
Another potential solution is to find a third-party buyer for the ownership interest of the Exiting Owners. The key here is that all the owners bind themselves in the Owners Agreement to seek out and encourage third-party buyers. On the other hand, some closely-held businesses do not want to bring in third-party strangers to the business. Thus, depending on the business and those involved, this might not be an option.
Contact San Diego Corporate Law
For more information, contact attorney Michael Leonard, Esq., of San Diego Corporate Law. Mr. Leonard has experience in buying and selling businesses, drafting Founder’s Agreements, and Buy-Sell Agreements among business owners. Mr. Leonard can be reached at (858) 483-9200 or via email. Like us on Facebook.