GUEST POST By Cliff Ennico
“I just started a limited liability company (LLC) with three partners. Our attorney drafted an Operating Agreement for us, but I’m a little confused by the buyout provisions he drafted.
The agreement says that if one of us dies, becomes disabled, or otherwise withdraws from the company, we have to buy his shares in the company so the remaining partners can retain control. So far, no problem.
The problem is that the agreement doesn’t spell out the buyout price. It says each of us (the company and the withdrawing partner) must pick an appraiser; the two appraisers then meet and determine the buyout price. If they don’t agree, the two appraisers must appoint a third appraiser, who will arbitrate the dispute and ultimately decide on the buyout price.
I’m not a lawyer, but it seems to me that this procedure is going to be very expensive and time-consuming. If one of us wants to leave the company, we certainly want to be fair, but we don’t want this dragging on for months.
Our attorney is telling us there’s really no other way to handle the situation as we’re just starting in business and there’s no foolproof way to value a startup company. Is that true?”
What you have described is what is commonly called a “pyramid” appraisal clause. I call it a “Three Stooges” appraisal clause.
Lawyers and accountants love this clause because, at least on paper, it seems very fair. Your attorney is right that there’s no foolproof way to value a startup company that doesn’t have revenues or profits yet, so why don’t let a team of experts figure it all out when there are some real numbers to look at?
The problem is that what looks good on paper doesn’t always work well in practice. In my experience when a “Three Stooges” appraisal clause is invoked by a withdrawing partner, what happens looks an awful lot like . . . a Three Stooges comedy.
First, the parties take forever to appoint the first two appraisers. Then, the appraisers take forever to review the company’s books and decide on a meeting date. Then, you get into tax season (the appraisers are often accountants or CPAs) so nothing happens for a few months while the appraisers clear their calendars. Then, the appraisers can’t agree on the buyout price and decide they really don’t like each other. Then, the appraisers stop talking to each other so a third appraiser cannot be appointed to resolve their dispute. And so on and so forth.
Meanwhile, your company is paying all these folks, probably by the hour, which I’ve always suspected is the primary reason lawyers and accountants love the “Three Stooges” appraisal clause – it’s a guarantee of future business (nyuk, nyuk, nyuk).
While your attorney is right that no single formula can properly value an early-stage company, there is a way to get the buyout price determined quickly, efficiently and fairly when a partner decides to leave the company (or is forced to withdraw).
Here’s how it works.
First, the Operating Agreement should clearly state that if a partner withdraws from the company, the buyout price will be:
- if the company is profitable, the withdrawing partner’s percentage share of the company’s average annual pretax earnings (EBIT) over the preceding five years (or the time the company has been in business, if less);
- if the company is not profitable, the withdrawing partner’s percentage share of the company’s average annual sales of the company over the preceding five (years) or the time the company has been in business, if less);
- if the company has neither profits nor sales (i.e. your company is still a startup), the withdrawing partner’s “capital account” (using the IRS definition of that term) as of the date the partner withdraws from the company; or
- if the withdrawing partner has no capital account (or a negative capital account, which sometimes happens), a nominal value such as One Hundred Dollars.
Second, the Operating Agreement should state that the company’s average annual pretax earnings and annual sales, and the withdrawing partner’s capital account, will be determined by the company’s independent accountant, “which determination shall be conclusive and binding on the parties in the absence of manifest arithmetic error.”
Third, in the case where a partner dies, the buyout price should be the “greater” of the amount determined above or the proceeds of any policy of life insurance the company has maintained on the deceased partner.
Lastly, the Operating Agreement should state that if a partner’s withdrawal is due to his bad behavior (for example, he committed a crime, embezzled money from the company, or failed to perform his duties), the buyout price is One Dollar.
While not 100% perfect, this method ensures a fair, reasonable and quick calculation of a withdrawing partner’s buyout price, enabling the remaining partners to do what they do best – run the business – without having to look out for flying cream pies.
Cliff Ennico, a leading expert on small business law and taxes, is the author of “Small Business Survival Guide,” “The eBay Seller’s Tax and Legal Answer Book” and 15 other books.