Bill and his wife Elaine had just arrived at the airport to depart for a week-long trip to the Caribbean for his company’s annual planning meeting. Bill had five other partners, each owning 12% of the company. As founder, Bill, owned the remaining 40%. Each year all of the partners and their wives gather at a resort for both business planning and pleasure.

The fiscal year ended June 30, so it was time to update the strategic business plan and re-examine growth strategies for the following year. The company’s revenues had just crossed the $18 million mark with pre-tax earnings of $3.2 million. It had been a record-breaking year for the company.

When Bill entered the airport terminal, he noticed that he had a little indigestion. After approaching the ticket counter to check-in, Bill started to feel a little nausea as well. After he and Elaine checked in, he drank some water and began to feel better.  At the gate, when the boarding call came, Bill and Elaine entered the jetway. Suddenly Bill could hardly breath and in a few moments he collapsed. Bill passed away in the jetway from a massive heart attack.

Needless to say, upon hearing the news, Bill’s partners returned home immediately. After the funeral, Bill’s partners met to determine their course of action. Their primary focus centered on how to buy-out Bill’s membership interest; how to structure a settlement with Elaine; and how to continue company operations successfully. They turned to their legal counsel to review the company’s operating agreement and help them understand its provisions.

An operating agreement is a contract among LLC members, and it spells out provisions relating to:

1. Equity structure
2. Management formation and duties
3. Voting rights
4. Liability and indemnification limitations
5. Books and records
6. Anti-dilutions protections
7. Restrictions on transfer of membership interests (assignability of interests; veto/approval rights; right of first refusal; permitted transfers; buyout provisions; tag-along and drag-along rights)
8. Confidentiality and restrictive covenants
9. Liquidation and dissolutions
10. General provisions

Many buy-sell agreements include other provisions as well:

1. “Call-rights” where the firm, at any time, can elect to purchase an owner’s interest for a premium, i.e., 125% to 150% of the fair market value.
2. “Put-rights” where an owner can demand the firm purchase his/her interest at a loss, i.e. 50% to 75% of fair market value.
3. Deadlock provisions where the owner can part ways or dissolve the firm.
4. Right of first refusal that allows the owner to sell his interest to a third party provided that the other existing owners refuse or waive their first right to purchase the owners interest.

After careful review, it became evident that many of the provisions listed above had been ignored by the partners, presenting potentially major problems.

First, the operating agreement specified a valuation of the company be completed every two years from an independent third-party valuation firm. The company had been in business for 13 years. No valuation had ever been conducted.

Second, the operating agreement called for the company to fund key-man life insurance for each partner. The purpose of the insurance was to have adequate capital to fund a buyout in case of certain events such as death, disability, bankruptcy, and/or termination of employment. The company had no life insurance on any of the partners.

Third, the operating agreement required that the company create a buy-sell agreement specifying the process and procedures of how the buyout should take place. For example, should a buyout be necessary, will it be paid in all cash as a lump sum, paid overtime, and at what price. No buy-out agreement was ever created.

Needless to say, the partners were in a quandary. They all agreed that a valuation of the company, from an independent valuation firm, was needed to ensure that Elaine was fairly compensated for Bill’s ownership portion of the company. They realized that the company did not have the cash to pay Elaine a lump sum for Bill’s ownership interest. Long before Bill’s passing, the partners had agreed to distribute all of the profits annually after retaining enough capital to fund the company’s operations.

Facing these problems, the partners agreed that a buy-sell agreement should be developed in case another life-changing event occurred. According to The CPA Journal, “… a (strong) buy-sell agreement should accomplish several objectives:

“It provides a mechanism for an orderly business succession should an owner decide to transfer his interest due to a voluntarily event, such as retirement, or an involuntary event, such as death, disability, or bankruptcy.” Should an event occur, “… the buy-sell agreement is a triggering event.”

In Elaine’s case, the partners were all amical and worked out a buyout arrangement so that Elaine would be fairly compensated. They paid her 136% of the fair market value of the company over a five-year period. In this case, all of the partners did what was “right.”

This case study is clear. If an operating agreement is not executed according to its terms and provisions, and a life-changing event occurs, more often than not, an environment is created for partner disputes. Even the most cordial business relationships can fall apart in the face of a crisis because of a “needless recipe for disaster.”

Gary Miller is CEO of GEM Strategy Management, Inc., a M&A consulting firm that advises small and medium sized businesses throughout the U.S. He represents business owners throughout the transaction process from preparing them to go to market, selling their companies, acquiring companies and raising capital. He has been a frequent keynote speaker at conferences and workshops on mergers and acquisitions. Reach Gary at 303.409.7740 or [email protected].

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