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Start Partnership by Planning Its Breakup

February 19, 1987|JEFFREY S. KLEIN

Breaking up is hard to do, whether you're talking about romance or business.

The breakup of a business partnership, just like a marriage, can be a painful, expensive, time-consuming process. Often, it leads to litigation.

And the best way to avoid it is to plan for it in advance.

That means having a written partnership agreement that clearly explains what will happen when one of your partners decides he wants out of the business or becomes disabled or dies. This is known as a "buy-out" provision.

Negotiating Compromise

If you don't plan in advance with a carefully negotiated buy-out clause, you will have to negotiate a compromise at the time when your partner decides to end the partnership.

Then, no doubt, emotions will be high, and it will be difficult to reach a fair settlement without winding up in court. And the business may have to be liquidated because partners who are suing each other generally can't continue running a business together.

You can have a lawyer draft the contract, but the hard part is not the legal language; it is trying to pick a method to value the business when the breakup occurs. If one partner wants to leave but the other partner plans to continue operating the business, then the parties have to figure out how much the business is worth, so that the partner who is departing can get his fair share.

You may also want to plan how the leaving partner will be paid, because a lump-sum cash payment may be impossible for the remaining partner to handle, if the business is to survive. So some sort of monthly-payment schedule might be appropriate.

Determining a realistic and fair value for an ongoing business is a speculative venture at best. It is difficult to evaluate the true value of a partnership business, because there is no readily identifiable market for most small businesses, no stock exchange, no regularly scheduled auctions, no competing buyers selecting different products.

Accountants and merger specialists have their own appraisal methods, but here are a few possibilities to consider before you consult your legal and financial advisers, which you should do in any event.

You could set a purchase price in advance. You and your partners decide how much the business is worth, set the price, and whenever one of the partners wants out, the remaining partners can buy his share at that price.

But if you're starting a new business, it will be almost impossible to preset a fair price because you won't know how well your business will do. If you're starting a hot dog stand, you can only guess how many frankfurters you'll be selling.

One way to deal with that uncertainty is to include an acceleration clause in the price, so that each year it will increase by a specific percentage. But that still doesn't take fully into account actual receipts.

Value Every Year

Some partnerships require the partners to value the business every year and use that amount as the buy-out price, if and when a partner leaves that year.

Another method of valuation is to agree to use an outside appraiser. You could select one in advance or use several appraisers picked by each partner and agree that the buy-out price will be the average appraisal.

The partners could agree that the "net value" of the business will be the buy-out price. Net value is determined by adding up all of the assets--accounts receivable, fixtures, leases, cash--and subtracting the liabilities. But that method does not take into account such intangibles as the value of a business' name or good will.

A common method of appraisal is the "capitalization of earnings" computation. First, you determine the average net earnings of the business, and then multiply it by an agreed-upon "multiplier."

There are common multipliers for certain kinds of industries, but basically you have to decide how many times the annual net profit the business is worth. If the business makes $25,000 in profits, is four times that amount, or $100,000, a reasonable price to pay for it?

Another buy-out method is to have one partner set a price for his half of the business, and then the other partner has the choice of either buying or selling at that price. Knowing that your partner can either buy you out at that price or force you to buy his share makes it more likely that you will arrive at a fair price. But, of course, that method doesn't help when one partner really wants out and the other wants to stay.

Starting a small firm, restaurant or retail store with one or more partners is a risky business. Most new ventures fail soon after they start. You'll have enough trouble getting customers, so don't complicate your life further with problems between partners.

Plan for your problems in advance with a solid, understandable partnership agreement that will help you value the business when one partner has to go.

Attorney Jeffrey S. Klein, The Times' senior staff counsel, cannot answer mail personally but will respond in this column to questions of general interest about the law. Do not telephone. Write to Jeffrey S. Klein, Legal View, The Times, Times Mirror Square, Los Angeles 90053.

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