The LLC Escape Door: The Importance of an Exit Strategy in Your Operating Agreement and the Mechanics of the Buy/Sell
There are many things to consider when drafting an Operating Agreement for a joint venture partnership. One important area that is often overlooked in drafting the Operating Agreement is the inclusion of an escape door, which generally involves crafting a specific and detailed exit provision in the document.
Why Is an Exit Strategy Important?
When two or more parties sign an Operating Agreement, the parties are essentially getting married to a particular deal or set of transactions. The parties, like in marriage, become partners. No one shows up on their wedding day assuming the marriage will end in divorce, but just like marriages, some business partnerships fail. For marriages that fail, the parties can file for divorce. When a partnership or joint venture fails, it’s important to have an escape door. The best way to ensure that each partner has a means to use the escape door is to include in your Operating Agreement a pre-negotiated provision outlining how either party can exit the joint venture. The most common reasons for a partner wanting to exit the joint venture are because of (1) a partner wanting to liquidate their investment, or (2) a deadlock on a major decision.
First, a partner may decide down the road that the money that they have tied up in the joint venture investment may be needed for some other purpose or other business investment. In such case, the partner would want to have the ability to exit the partnership and liquidate their investment.
Second, the business goals and motivations may change and a dispute may arise between the parties about the future course of the venture. Typically, the business mechanics of the deal will provide one partner with the right to control all decisions of the partnership except for certain pre-negotiated “major decisions.” Major decisions are usually those actions and decisions that are so fundamental to the business or the partners’ intent of entering into the deal that all of the partners should have the right to approve or disapprove of them. But even then, there may be a specific economic circumstance when one partner has “veto” power over even those major or fundamental decisions of the partnership. In any case, a partner may want the ability to exit the partnership, recoup their investment and move on. Without a pre-negotiated escape door, all partners are stuck in the partnership and their exit is based on the whim and generosity of the partner with control of the decisions. While there are a number of different exit mechanisms that can be added to an Operating Agreement, the most common way to avoid this scenario is to draft what is commonly referred to as a “Buy/Sell” provision.
What Is a Buy/Sell?
A Buy/Sell is a right of one partner (possibly, after a set period of time) to initiate a process under the Operating Agreement to either (1) buy out the other partner’s interest in the partnership, or (2) sell their interest in the partnership to the other partner; however, the initiating partner does not know at the outset of triggering the Buy/Sell right whether they will be forced to buy out the other partner’s interest or sell their interest to the other partner. At the end of the Buy/Sell process, one partner will be the sole owner of the partnership and the other partner will have liquidated their investment in the partnership.
How Does a Buy/Sell Typically Work?
The Buy/Sell provision in the Operating Agreement should be carefully drafted to specify the procedure if the Buy/Sell is exercised by a partner and a methodology for determining valuation or pricing. In the case of a Buy/Sell, the initiating partner must elect to exercise the Buy/Sell right and put forth a price for the partners’ interests in the partnership. Once the price has been determined by the initiating partner, the other partner may elect to sell their interest or buy the initiating member’s interest at the price set forth by the initiating member. The value or price of the partnership interest is determined by the initiating partner through any methodology they choose and not through a fair market value arbitration approach more commonly associated with a put or call right. The Buy/Sell right provides finality in the separation process, a relatively easy method to determine what must be paid to close the transaction and minimizes dispute between the parties. Also, because there is no need to involve third-party brokers or appraisers in the valuation/pricing process, the Buy/Sell right tends to be a more efficient and expeditious way of exiting the partnership. The Operating Agreement should include all terms related to the closing of the transaction, including allocation of closing costs, representations and warranties, closing timelines, payment terms, deposits, conditions and default and termination right.