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Business Breakups

Legal Briefs
Business Breakups
Preparation pays off when partnerships dissolve.
by Cara Lowe

Given commercial real estate’s protracted downturn, brokerage arrangements, investment groups, and client partnerships may be on shaky footing these days. While breaking up is hard to do, learning how to do it successfully can help all business participants to pick up the pieces, pack up, and get on with their lives.

Asking the Right Questions

To avoid a long, exhausting battle, partners should consider the following questions.

Is there a prenuptial agreement?
Well-advised business owners create a buy-sell agreement — at the start of their partnership — that outlines situations in which the parties can part ways. The “four D’s” — death, disability, disagreement among the parties, or personal divorce — are typical triggers, but an effective buy-sell agreement addresses issues specific to the parties or the project that might trigger a buyout. The agreement also outlines how the parties can fairly and accurately price the bought-out interest and clearly articulates the payment terms.

If the buy-sell terms fall short or become stale, the parties have to negotiate new terms outside of the agreement, which may be difficult if relationships sour. If all else fails, they can consider a voluntary or involuntary dissolution of the company under applicable corporate or partnership law.

For operating businesses, such as real estate development, management, and brokerage companies, the standard buy-sell provisions discussed above should be located in the owners’ shareholder agreement for the operating company. Different provisions might exist in the partnership or operating agreement prepared for the separate partnership or LLC entity in which investors participate. Typically investors have few, if any, rights to withdraw their capital from a private or non-public investment.

In contrast, a joint venture between a service partner, such as a developer, and a finance partner, such as an institutional or lead investor, usually sets forth detailed scenarios — based on performance milestones, budgetary thresholds, and other objective metrics — in which the service partner’s interest can terminate or the finance partner’s interest can be “put” to the company.

In addition, real estate entities likely are subject to various bank and other third-party covenants or restrictions that limit the options available to the parties. Thus, those contractual obligations require consideration in order to avoid a technical breach under those agreements.

How do you value the buyout?
When preparing a buy-sell agreement or negotiating the terms of the buyout, the parties need a valuation mechanism that they mutually accept as realistic, relatively accurate, and fair. With an operating company, the owners themselves usually are best equipped to select the appropriate valuation process, with support and input from the company’s accountants, third-party appraisers, or other industry experts. However, valuation is complex and involves weighing all factors that could impact the company’s bottom line, including current and future revenues and liabilities. Further complicating the process is the fact that the value of development projects and investments is uncertain until completion.

The downturn has caused property values to erode significantly in many markets, but buy-sell provisions might still apply. For example, the buy-sell might provide for a put option, where the investor can force the company to liquidate its interest, or a call option, where the company can force the investor to sell its interest. If no viable options exist, then the owners have to consider remaining together, negotiating a buyout, or selling the underlying asset.

Regardless of how the buyout surfaces, the parties need to consider the tax consequences to the company, the departing party, and the remaining parties. These include any income recognition related to a departing party’s negative capital account or any potential transfer tax or property reassessments that might be triggered by the change in beneficial ownership interests in the underlying real estate assets.

When can you tell the “kids” (your team and staff)?
Often one party pulls the plug suddenly, forcing the others to scramble to retain key talent and develop a communication plan. Express nonsolicitation covenants may prohibit the departing owner from soliciting employees and clients before and after departure. In the absence of such contracts, fiduciary duties under state partnership, corporate, and LLC law may forbid officers, directors, partners, and majority shareholders from soliciting other employees, owners, and clients prior to the departing party’s effective resignation and ownership interest termination.

When can the parties start dating?
Many buy-sells include noncompetition covenants that restrict the departing party from competing with the company and/or soliciting clients. Most states enforce reasonable restrictive covenants. In a few jurisdictions, such as California, noncompetes are unenforceable unless the situation falls within a statutory exception.

Can the parties walk away with a clean slate?
Whenever a buyout comes into play, the parties need to consider granting a mutual general release, where both sides release each other from all claims.

In real estate companies and ventures, a general release might not be appropriate if misconduct is suspected or personal guaranties of third-party liabilities remain in place after the parties part ways. The parties need to take into account all of the liabilities and risk that exist or could arise after the breakup. Any termination agreement that memorializes the parties’ breakup could contain expansive representations and warranties about those issues and other relevant facts. In that event, the parties could give mutual general releases and still have recourse against a party that breaches the representations and warranties given to the other party.  

How do you announce the change to the outside world?
The parties should establish “game rules” at the start of negotiations, including an agreement to keep the breakup, negotiations, and all terms confidential until they sign a written settlement agreement. To encourage fair play after they part ways, the parties also might consider adding a nondisparagement covenant to their termination agreement.

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Cara Lowe is managing partner for Stein & Lubin in San Francisco. Contact her at clowe@steinlubin.com.

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