When you own a business, you appreciate just how much your personal financial life is tied to your business. What you may not realize is how much your personal financial wellbeing is intertwined with your partners or other owners in your business. If you own a mature, successful business, and you’re seriously looking at your exit strategy, how well you’ve addressed this connection among partners can mark how successful your exit — and the funding for the next phase of your life — will be.
As financial advisors, we have worked with business owners both as they have built their businesses and exited them. Amid the success stories, we have also witnessed times where owners lost significant value that derailed their personal financial planning for retirement or their next venture. What is often the determining factor? Well-documented buy-sell provisions in the operating agreement of the business.
“Paper is to write things down that we need to remember,” Albert Einstein wrote, before adding that “our brains are used to think”.
Business partners often think they are in alignment about operating the business; however, memory is unreliable even for things that have seem to have been fully discussed. Getting your Partnership Agreement (or Operating Agreement in the case of an LLC) written down forces you to clarify situations that may be vague or subject to assumptions. These explicit, documented agreements can make all the difference in successfully exiting your business and preserving your financial future.
The three most critical agreements to spell out that will help you protect your personal financial life are:
- Contributions and Distributions: Setting rules for making decisions about personal money coming in to the company and payouts from the business to your personal accounts will help you as the business grows.
- How will you decide about the need for additional infusions of capital?
- What are the targets for partners to take profit distributions?
- How and when will debt be used?
- Dilution: Your equity share of the company directly affects your personal finances, especially upon exiting through a sale or buyout. Make sure your agreement addresses the method and criteria for bringing in new partners. How much ownership are existing partners willing to surrender? What is the schedule for buying into the partnership? How will new ownership affect current ownership shares?
- Exits: What happens when a partner or owner wants to, or has to, leave the business? No one wants to think about this possibility at the start of a venture, however, to protect the continuity of the business and your personal finances you will want to have contingencies in place for:
Death or disability of an owner: Most business owners choose their partners carefully, and should something happen to them, it can be extremely difficult to continue with that person’s spouse or adult children as co-owners. This can happen when there is no plan in place to invoke a buyback of their shares. The good news is that this can be solved with purchasing insurance to provide liquidity for a buyout.
A partner who chooses to leave: Buying out a partner who decides to exit puts pressure on business cash flow, so some agreements place restrictions on the timing of payouts. Important considerations involving client access, future competition and the right to intellectual property should also be included.
In either case, you want to document the valuation method you will use for the business to complete the exit.
The reality is that urgent business matters and the uncertainty about how the business will evolve stops many business owners from documenting an explicit agreement about exits that they cannot yet comprehend. The best time to get these provisions in writing is at the start of the business, allowing for flexibility to make changes as your company develops. But, if you do not have a clear operating or partnership agreement in place, it is not too late to create one. Meet with your partners to outline these provisions. Even if you do have a solid agreement in force, make sure you review it for these three elements to ensure you protect the personal financial health of you and your partners.