3 Provisions in Your Governing Documents to Facilitate Exits and Minimize Partners’ Disputes
You and your partners have spent years building your business. Together, you survived the early chaos and managed to grow the company. Operations are flowing, pipeline looks healthy, and the business is sitting at an all-time high. Then, something happens: a tragic death, a simple disagreement that turns into an irreconcilable dispute, or a potential buyer offering to purchase the business. And that is when something buried in your operating agreement (or similar documents) that you signed years ago without a second thought becomes a major roadblock.
It happens more often than you would expect. An issue that was entirely preventable turns into prolonged and costly disputes among business partners or their successors.
Here are three key provisions that will shape certain business exits and are generally must-haves for your business:
1. Buy-Sell / Triggering Event Provisions
A buy-sell provision in your governing documents establishes what happens when an owner wants or needs to leave the company. It covers the circumstances that can trigger a buyout, such as:
- Death
- Disability
- Termination of Services or retirement
- Voluntary or involuntary departure
- Involuntary transfers or transfers by operation of law (such as bankruptcy or divorce)
- Breaches or non-compliance with certain obligations
- Disagreements with other managers or members
In each of these scenarios and others, the key question is how the departing member’s interest will be valued and paid for. Well-crafted buy-sell provisions typically identify, at a minimum:
- A list of triggering events;
- A voting process among partners to vote on whether a triggering event has occurred;
- A process to value the partner’s interest, including the valuation methodology, the individual(s) who will value the interest, and how to handle disagreements over the valuation;
- A clear timeline during which all the steps must be accomplished and the sale of the partner’s interest be consummated; and
- The documents to be executed during the buy-sell process, specifying, for example, whether the entire purchase price for the interest is to be paid at closing or in installments via a promissory note.
A poorly drafted buy-sell clause might lock you into an outdated valuation formula that could undervalue your interest, or it might give remaining members years to pay you out in installments while you wait on the sidelines and take on unnecessary risk. Vice versa, certain buy-sell provisions may be too onerous to the company and its remaining partners, which could run the business into a cash flow issue.
2. Drag-Along Rights
Drag-along rights allow majority owners to “drag” minority owners into a sale transaction. If a buyer wants to acquire 100% of the company and the majority agrees to sell, drag-along provisions force minority members to participate on the same terms.
For majority owners contemplating a sale, drag-along rights are essential. Without them, a single minority member can hold up or torpedo an otherwise simple transaction. Buyers generally want full ownership of the business. A holdout minority interest creates complications that can kill a deal or significantly complicate the sale process.
Similar to the buy-sell provisions above, well-drafted drag-along provisions leave no doubt as to the voting threshold to trigger the sale, the obligations of both majority and minority owners (both during the sale and under the definitive agreements), and the overall process from inception to closing. They often address the role and responsibilities of the seller representative representing the owners, notice requirements, dissenters’ rights or rights of appraisal, and remedies against non-responsive owners.
Drag-along provisions are complex creatures. They require precise drafting to capture the desired outcomes and ensure they work in tandem with the rest of your governing documents, such as any rights of first refusal in favor of other owners and other transfer restrictions.
3. Restrictive Covenants
When an owner departs, whether voluntarily or involuntarily, the company's goodwill, client relationships, and competitive position are immediately at risk. Restrictive covenants in your governing documents (or separate agreements) are the safeguards that keep a departing partner from taking what the person learned and using it against the company. These typically include confidentiality obligations that protect proprietary information, non-compete clauses that prevent a former partner from jumping straight into a competing venture, and non-solicitation/non-circumvention restrictions that prevent poaching clients, vendors, employees or other business parties.
When these protections are not negotiated in the early life of the company, owners often find it far more difficult—and far more contentious—to raise them for the first time near or during an exit event. But the opposite problem is just as dangerous: poorly drafted covenants that are overly broad or unworkable can expose all parties to costly disputes and delay the exit process.
Plan Your Exit Today
Your governing documents or founders’ agreements are not just administrative paperwork. They have important ramifications to your business and can dictate whether an exit is smooth and lucrative or contentious and costly. This article focuses primarily on the impact of these provisions upon exit, but the same provisions also impact other aspects of your business, such as fundraising opportunities.
If you and your business partners have not reviewed these agreements recently, or if you signed them years ago without fully understanding all their implications, now is the time to take a closer look. An experienced attorney can help you identify potential problems before they become deal-breakers, as well as draft and help you negotiate tailored legal provisions to protect your interests when exit day arrives and beyond.
If you are planning an exit and want to approach the sale with the same diligence and professionalism that you brought to building your company, please feel free to contact me at sriva@norris-law.com.
About the Author – Biz Law Blog
Samuele Riva is an associate in the firm’s Business Law Practice, focusing on mergers and acquisitions, strategic transactions, and corporate governance matters. He advises startups, emerging growth companies, and established businesses on capital raising, investments, exit strategies, and commercial contracts. Samuele regularly works with founders and business owners on venture and angel financing, early-stage agreements, and preparing companies for outside investment. He is fluent in Italian.