When starting a new business with an equity partner, it is easy to overlook that there might come a time when one of the partners wants or has to buy out the shares of the other partner. This can occur because one partner wants to leave the business completely or own it all by itself. Planning for these scenarios from the beginning helps eliminate ambiguities or personal battles down the road. This contingency should also be documented in the partnership agreement.
Handling These Situations in the Partnership Agreement
You want to include three elements in a partnership agreement for buying out an equity partner: transition, valuation, and payment terms. The language used in these sections should protect both partners and set crystal clear expectations about what happens if a sale situation arises.
It is important to include the terms about how the business and personnel will transition from pre-sale to post-sale. Include items such as how the duties of the leaving partner are going to be taken care of and who will take care of them, the transition timeframe of the deal, and whether either partner has the right to replace its spot in the partnership with another entity. You also want to include any information about deal options either partner may have, such as put options or right of first refusal. Any language or clauses unique to your business’ operations also go in this section. Do not include valuation or payment terms since they go into their own sections in the partnership agreement.
Business Valuation Clauses
You want to include details about the valuation method used for the business so no financial misunderstandings occur in the future. Beyond just a description of the method, you can include an example calculation to further reduce the chance of ambiguity. If many methods of valuation are acceptable, list the methodologies in preferred order. It is your business so you can customize this any way you see fit.
Payment Term Clauses
This section simply needs to state what forms of payment are acceptable for the equity sale and when they are due to be paid to the partner selling its shares. These terms are easy to create but very important to document since the payment terms often cause legal battles. Be objective and clear in this section, leaving no room for misunderstanding.
What if a New Equity Partner Comes Into the Business?
After the sale is complete, there might be a situation where a new equity partner joins the business. Brand new terms for the above three points need to be drafted, agreed to, and included in a new partnership agreement. Even if the partner on the buying side of the original sale is the person selecting and bringing on a new equity partner, this doesn’t eliminate the importance of drafting these clauses as protection for all partners involved. Since another equity sale of partner shares can occur at any time, it is best to be prepared from day one.