Business Breakups Needn’t Be Difficult

Business partnerships, like marriages, can end in “divorce.” Whether you exit with an equitable share of the business and intact relationships with your partners depends on proper planning.

Suppose you and your close friend establish a niche service business as equal owners. You provide the capital to get the company off the ground, while your partner manages the day-to-day operations and provides the consulting services. The company operates at a loss during the first few years, requiring you to inject additional capital to keep it afloat. You and your partner agree orally that the additional cash infusions are loans, which are to be repaid before distributing any profits once the business is in the black.

The following year, the company becomes profitable, but your partner wants the company to begin distributing profits to him, in addition to the sizable salary he has been receiving, before repaying your cash advances. You and your partner are at an impasse, which begins to disrupt the business. You decide that you want out, but you and your partner cannot agree on a fair price for your stake in the company. The partnership agreement is silent with regard to an owner withdrawing from the business, so you both hire attorneys. After months of quarreling and thousands of dollars in legal fees, you negotiate the sale of your interest to your partner. When the dust settles, the business has been damaged by the infighting, and your friendship with your former partner is history.

Unfortunately, we have seen just this scenario happen in real life. Going into business with others is not to be taken lightly, especially if your potential partners are friends or family members. Because of personal relationships, people tend to forego certain formalities, such as planning for the eventual exit of one or more partners, in order to kick-start the business. Yet the best time to plan for possible negative outcomes is before the partnership is consummated, so you should include an exit strategy in the shareholder or partnership agreement. If you are already in business and the existing agreement does not include a withdrawal mechanism, you and your partners should hire a competent attorney to draft one while everyone still gets along.

Even if the partnership is a success, there are many reasons to have an exit strategy in any partnership agreement. What if your business partner dies or becomes incapacitated? Or gets divorced and is required to give her ex-husband an ownership interest in the business? Or wants to sell her share of the business to a third party? Or declares bankruptcy and has to relinquish her share of the business to creditors? Any of these events could derail a thriving business and jeopardize the value of your stake in the company.

Buy-Sell Agreements

Many closely held businesses use a buy-sell agreement to provide an effective exit process. Like a prenuptial agreement, the buy-sell agreement protects the financial interests of all parties when someone wants to leave the business relationship. A buy-sell agreement usually spells out when an owner is allowed to sell his or her interest, who is allowed to purchase that interest, and how to determine the price that will be paid.

A well-drafted buy-sell agreement can provide these benefits:

Control. The company, the remaining partners or both are often granted the right of first refusal to purchase the departing owner’s interest. This reduces the likelihood of the remaining owners becoming business partners with a stranger or an otherwise undesirable third party.
Liquidity. The withdrawing business partner has a clear means of converting his or her ownership interest into cash.
Valuation. As in the case I described at the beginning of this article, determining the value of a seller’s interest in the business often is a major source of controversy. A good buy-sell agreement provides a formula (such as a multiple of sales or cash flow) or a mechanism (such as an appraisal) to determine an appropriate price for the seller’s interest. The agreement also should provide for arbitration or some other method short of litigation to resolve any disagreements.
Preservation of advantageous tax treatment. An S corporation is referred to as a “flow-through” entity for tax purposes because business profits are taxed solely at the shareholder level, unlike with C corporations (e.g., publicly traded companies), for which profits are taxed at both the corporate and shareholder levels. To maintain the more favorable tax structure, the Internal Revenue Service is selective about who can be a shareholder of an S corporation. A buy-sell agreement can include provisions restricting a departing shareholder from transferring his or her shares to a person or entity that is not a permissible S corporation shareholder.

Don’t forget that the buy-sell agreement needs to be funded in order to work. The agreement may provide for the company or the remaining owners to buy out a departing investor, but the prospective buyers must have access to cash or financing. Otherwise, the seller typically is free to sell to an outsider, which may defeat the purpose of the agreement.

The buy-sell agreement frequently will require the individual partners to take out life and disability insurance on one another, or the company may be required to purchase insurance on each owner, in case someone has to withdraw as a result of death or injury. For a voluntary withdrawal, such as when an owner decides to retire, the agreement often allows the remaining partners or the company to purchase the interest in installments over a specified period of time, such as five or 10 years.

The three main types of buy-sell agreements are cross-purchase, redemption and hybrid.

With a cross-purchase agreement, the other owners will acquire the stock or interest of the departing owner. From an income tax perspective, this is most advantageous to the remaining owners. By purchasing additional ownership units, their cost basis in the company increases, resulting in less capital gain realized upon a subsequent sale of the business.

To deal with a premature death of a partner, a cross-purchase agreement typically requires each owner to take out insurance on the lives of the other co-owners. If there are a large number of partners, such a program can be rather expensive and difficult to administer. Therefore, this method is best for a company with only a few owners. Further, at the death or withdrawal of an owner, the policies held by that individual must be assigned to the remaining partners. If not handled properly, these policy transfers can result in the unintended taxation of the insurance proceeds under the tax code’s “transfer for value” rule, leaving less money available to acquire the departing owner’s interest.

Under a redemption (or entity purchase) agreement, the company will acquire the interest of the exiting partner. It is easier and less expensive to use life insurance to fund a redemption plan, because only a single policy, owned by the company, is needed on the life of each owner. A policy on the life of a partner who retires or sells his interest prior to death can be transferred to the withdrawing owner without triggering the transfer-for-value rule. Redemption agreements are often used in companies with three or more owners because of this ease of administration. The downside, however, is that the remaining owners will likely realize larger capital gains (and therefore will pay higher taxes) upon the subsequent sale of the business than they would with a cross-purchase agreement. This is because the business generally cancels the interest it acquires from the departing owner, increasing the value of the remaining owners’ interests proportionately without increasing any owner’s cost basis. Also, if the company is a corporation, the collection of the insurance proceeds could result in the issuing of dividends to remaining shareholders, which would be taxed as ordinary income after 2010, assuming special treatment for “qualified dividends” expires this year as scheduled under current law.

The most flexible option is the hybrid agreement, because the owners agree to sell their interests either to the other owners or to the company itself. Under this method, the buy-sell agreement will give the other owners the first option to purchase the interest, and if they refuse, the business will have the second option. This structure allows the remaining owners to wait until a withdrawal is proposed to determine how to proceed.

The Makings Of A Successful Partnership

Couples that are getting married do not intend to divorce, and partners who are starting a business do not intend to soon split up. But things do not always work out as planned. To give your partnership the best chance of succeeding, follow these steps:

Make sure you know your potential business partners well before tying the knot. Communication between you and your soon-to-be partners is essential, not only when you are in business together but also during the planning stages. Each person should discuss his or her expectations for the business, as well as the roles and responsibilities of each owner. If your goals and expectations are not aligned, this is a clear sign that the partnership is not meant to be. This exercise will save everyone a great deal of time, effort and money, whether or not you decide to move forward.
Document everything. When decisions about the business are not in writing, too much is open for debate once an issue arises. The shareholder or partnership agreement should clearly state when profits are to be distributed and how conflicts are to be resolved.
Hire a good attorney. Do not try to cut costs by drafting the shareholder/ partnership agreement, buy-sell agreement or loan documents yourself. This will only cost you and your partners more in the long run. Hire a business attorney with experience drafting such agreements. In some situations, especially when partners are at different stages of their careers or have different roles in the business, it is wise for each party to be represented by his or her own counsel.
Understand that business can end the best of friendships. Even if all of your agreements are well-drafted, there is one thing they cannot account for – the emotional aspect of a breakup. You and your soon-to-be partners should discuss the possibility that the friendship may not survive the business venture. Make sure this risk is worth taking.
Have an exit strategy. All good things eventually end.

Small Businesses and the SBA

Small businesses serve as the backbone to a nation’s economy. They are the critical factor in ensuring the recovery and growth of any economy. Governments around the world are aware of the significance of small businesses and thus instituted programs that would encourage, assist and support this sector of the economy. In the United States, the government agency that is tasked to provide support to small businesses is the Small Business Administration (SBA).

If you think you have a good idea for a product or service that would sell, you should try to make a go of it. While it is true that it is difficult to start a business and that you will have to take some risks, there are steps that you can take to increase your chances of success. Be sure to do your homework before risking your lifetime savings on your new business venture. Study all that you can about the industry or line of business you want to enter. Look into the viability of your idea and test the feasibility of the business you have in mind. Write a business plan so you can put your many ideas into a cohesive plan of action.

There are many online resources that can be of big help during your planning phase. The SBA website (SBA.gov) is one valuable online resource and you may want to check it out first. The SBA’s small business planner on the site provides highly informative material that can assist you at any stage of the business life cycle.

The Small Business Administration

The SBA was established in 1953 by the US Congress with the goal of maintaining and strengthening the country’s economy by way of establishing small businesses, as well as assisting in efforts for economic recovery of those communities after disasters. The SBA’s basic functions include aiding, counseling, assisting, and protecting the interest of small businesses.

Although many think immediately of loans when talking about SBA assistance for small businesses, the SBA by itself does not offer loans to small businesses. It has numerous loan programs, but the SBA acts only as a guarantor of loans made by private lenders and other institutions. The only loans that the SBA grants directly to borrowers are the Disaster Relief Loans.

Other SBA services include technical assistance, training and counseling in entrepreneurial development, women business ownership, Native American affairs, and international trade, among others. The SBA also provides assistance to businesses seeking government contracts. You should be able to receive support and assistance from the local SBA office near you.

If You Need Loans and Financial Assistance from the SBA

You will need to be eligible to apply under any of the SBA loan programs. Primary consideration is the repayment ability from the cash generated by the business. Other factors considered are good credit and character, management capability, collateral, and owner’s equity contribution. All owners that have a stake of at least 20% in the business are required to personally guarantee the business loan obtained through the SBA.

There are several business loan programs being offered by the SBA but the most basic and common type of loan applied for by small businessmen is the 7(a) loan. The 7(a) loans are known as such because they refer to section 7(a) of the Small Business Act, which authorizes the SBA to provide business loans to American small businesses.

Most American banks and some non-bank lenders participate in the 7(a) program of the SBA. They provide the loans to small businesses following SBA guidelines in exchange for a guaranty from the SBA against payment default. However, the SBA does not fully guarantee 7(a) loans as a precaution against irresponsible decisions by the lender or misrepresentation by the borrower. Under this program, lenders arrange and administer the loans.

Bank on It – Why Having a Business Bank Account is Essential

There are many reasons why a new business owner may forgo opening a business bank account and struggle on using their own personal account for their business transactions. Sometimes they simply run out of time, having focused on everything else and forgotten to open a business bank account, they suddenly realise that it cannot be done instantly and so opt to carry on using their personal account. Other times it is through lack of conviction, fear of business failure leads them to bulk at putting the business finances into black and white. Most often, though, it is in the mistaken belief that it will save them a little money if they do not have to fork out for business banking fees.

Not paying to have a separate business account can often prove something of a false economy, as, for the small amount that most business accounts might cost, a business can gain so much more than just a bank account.

The way that customers and other businesses with which you do business view you is very valuable; image is everything in business and having your business transactions move through a personal rather than a business account smacks of small time; your business is far less likely to be taken seriously and plenty of customers will be put-off by the impression of paucity it creates.

Trying to do business accounts when using the same account for personal and business finances has the potential for absolute disaster; even allowing for not making any important fiscal errors, the sheer time consuming nature of fussing around separating everything out will be very trying for most new business owners.

Make no mistake, HMRC will be watching you; there will of course be times when you will have to have contact with them, provide them with information etc. and other times when they will just be watching. Mixing personal and business bank accounts may cause them to look a little harder at you and your business, as it makes financial transparency more difficult to demonstrate at a glance. If the Tax Man wants to see that you are declaring everything you should, having to fight through hundreds of domestic transactions to locate those of the business will not endear you to them.

Business accounts can provide your business with more than just banking facilities; many banks will throw-in added extras, such as accounting software, deals on insurance and even offer the actual banking services free for the first year or more of business. They are also a great source of financial advice for the new business owner.

So, rather than viewing a business bank account as an extra overhead on your new business, perhaps you could look at it in terms of what it can provide in benefits for your venture. If a business bank account can help your business profile or simplify its record keeping maybe it is worth the effort of setting it up, if it can also help the authorities to look favourably on you and throw-in a bit of guidance and some cheap insurance to boot, well then maybe it becomes an essential to add to your list.