Tag Archives: buy-sell agreement

Q&A: Is This Partner Arrangement Fair?

I get these emails, summarizing one side of an argument, asking me to guess or comment on fairness. For example, in an email I just received, the one asking me has worked for 18 months “with significant intellectual contribution.” He’s apparently resenting the other partner, who has shelled out $560,000 and wants a guaranteed payback before other partners get it, and ends up with 65% ownership. The question:

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Isn’t that excessive? 

I can’t even start to answer that without asking questions first: 

  1. Was there no agreement before you started those 18 months working? Really? Or are you wanting to change what you agreed? 
  2. Did you put in no money? If not, did you work for ownership, without being paid? And if you didn’t work for free, then why doesn’t the partner who put in all the money and paid your salary own it completely? Why only 65%? How can that be excessive? 

My advice is to get professional help. Ideally you find somebody you can both trust, with some professional qualifications and experience, and talk it through. Make sure that person understands business, business law, and small business. 

There are people who have licenses and professional qualifications to call themselves mediators. Pay somebody to help you solve this. 

What I particularly hate in this context is when people spend the time and do the work and develop the business without spelling these things out, and then, when it’s way too late, discover that they had radically different ideas about who owns what. 

Way too often, you can add up the percent of ownership in the heads of the partners and discover between them they think they own like 200% of the company. That’s because one thinks the idea was worth 50% or more of the ownership, the other thinks the day-to-day work was worth 50% or more of the ownership, and another thinks having written checks and invested was worth 50% or more of the ownership.

My first instinct is to go with the money. The one who put in all the money deserves all the ownership. That’s simple enough. 

On the other hand, if two partners agreed that one would earn ownership by working for free or less than market rate, then that can equate to money. Or if one contributes existing intellectual property such as written material or software code, that can equate to money too. But that should be spelled out and agreed upon before you start. 

And I personally don’t believe having had the idea, or not, matters. Ideas have no value. Work has value. Creative work and patents have value. Content has value. And money has value. Ideas don’t. 

To me this is yet another example of why I’ve said, and written, over and over again, get it in writing. Not necessarily all legalese like a contract, but at least the basic points of agreements, with signatures. Here‘s what one lawyer (and I’m not a lawyer, so don’t think I’m giving you legal advice here) says about that:

It goes without saying: the best way to deal with a botched verbal contract is to avoid the whole mess in the first place. Get it in writing. People remember things differently. People don’t remember. People lie.

Get it in writing. And then stick to it. 

Sticky Questions on Startup Ownership and Buy-Sell

I received this interesting detailed question from the ask me form on my website. I’ve decided to answer it here. I think my answer might be useful for others with similar questions. I’m putting the question in quotes, paragraph by paragraph, and adding my response directly where it comes in the question. 

It starts like this:

A person ‘X’ owns 15% stake in a startup company – not by investing money but purely by virtue of having dedicating hours for building a product for the company. No salary was to be paid as per an initial agreement. The 15% stake was deduced by a simple calculation: (value of company) / (number of hours worked) x (dollars per hour).

Was it clear in the initial agreement that the formula here was to be used in future buy-sell transactions? Was that agreed to by all? 

The question continues: 

The value of company is therefore, sum of [(number of hours worked) x (dollars per hour)] and [hard cash invested by a person ‘Y’, also taking into consideration year-on-year appreciation of this hard cash]. Lets call that VC.

No, it’s not. The value of the company is what somebody pays for it when they buy it. And if nobody is buying it, then the value of the company is an estimated value. There are lots of formulas for estimating it, and estimates will vary widely. I’ve got more on that below, in my specific recommendations. 

However, it could be valued like you propose, for purposes of a buy-back transaction, if there was a buy-sell agreement that set that formula in the beginning. That’s if and only if. Issues like these are the reason experts recommend that partners and cofounders talk about the eventualities and agree, before the business starts, on how they’ll be handled. You have to agree beforehand or you’re stuck with arguing and negotiating the valuation afterwards. And when you try to pull it apart afterwards, without the benefit of an agreed-upono buy-sell formula, then many formulas might apply. 

And here’s the heart of the question: 

The company is not profitable yet. Person ‘X’ decides to give up his 15% stake of the company. My questions:

– How much is ‘X’ entitled to receive as the value for 15% stake? 
– Calculating backward, would X receive as much as [(number of hours worked) x (dollars per hour)]? 
– How does this change if the only buyers of the 15% stake are also two other stake-holders within this company, one of them by virtue of cash invested in the company, and the other by virtue of hours spent working for the company?

Normally, unless otherwise specified, owning 15 percent of a company means you own some shares that amounted to 15 percent of the total shares issued when they were issued. Ownership privileges are defined in company documents. You might have a seat on a board of directors, or not. You might get dividends when that’s relevant. And you’ll be able to sell those shares subject to securities and exchange regulations. 

Just hypothetically, as an example, say you agreed two years ago that you got 15% because you had put $15,000 worth of work on it for free and the founders agreed then that it was worth $100,000. If it’s launched and very successful now, with sales of $1 million annually, then it’s worth something like one or two times revenues, less a discount for debts, less a discount for not being liquid. In that case your 15% is worth something like $100,000. On the other hand, if it launched, has no sales, no profits, and has spent all its money, then your 15% is worth about zero. Companies are almost never worth a formula based on hours worked. 

So unless you have that buy-sell agreement stipulating the formula you’re using, then it doesn’t apply. Here’s what I recommend. 

  1. Agree on an estimated valuation. The formula you’re suggesting seems like it might be one-sided and self-serving. Good luck with it because it’s going to be hard. Expect disagreements. Depending on how much money is at stake and how severe the disagreement, you might need to work with an attorney and a valuation expert you can agree on. Here are some posts on this blog about valuation. This one is particularly relevant: 5 things business owners need to know about valuation. Sales, sales growth, profitability, and scalability and defensibility make it worth more. Debt, and not being liquid shares, low growth, and losses make it worth less. 
  2. Take 15% of that valuation and negotiate with your cofounders based on that value. I hope for your sake and the sake of your cofounders that things are going well for this business and they’re happy to buy you out. If they aren’t, then you’ll have to keep discounting until you get to an amount they’ll pay you. Or just keep your 15% of the shares, stop working for the company, and hope that someday they’ll be worth something. 

The moral of the story: please, the vast majority of business marriages (partnerships, startups with founders, etc.) end in divorce. Do a business pre-nuptial agreement, which is what they call a buy-sell agreement. 

 

 

Greatly appreciate your response and all your help!