ending a partnership

When it comes to difficult business situations, the contentious breakup of a partnership can be almost as stressful as getting sued or declaring bankruptcy. In fact, few things cost a company more, or cause its owners more emotional distress, than going through what’s often described as a “business divorce.”

Yet partnership dissolutions are relatively common, occurring when there are personality clashes, one partner loses interest, someone steps down due to illness, or there are competing visions for a company’s future.

These breakups don’t have to turn sour, but given human nature, the substantial assets involved and the demands of business ownership, it’s not surprising that they sometimes do, says New York small business attorney Rubin Ferziger. And things can become particularly fraught in family-owned companies: “Parents, spouses, cousins – everyone gets involved and feels they have to choose sides,” he says.

What no one wants is for a partnership to land in court, where legal fees can quickly eat away a company’s capital. So here are some rules of the road for when a partner wants – or needs – to go.

Make a business “pre-nup.” In the whirlwind of business startup, when everything looks rosy, partnerships often gloss over important details like executing proper legal documents, says Hanna Hasl-Kelchner, a Chapel Hill attorney and chief executive of consulting firm Business M.O. But putting partners’ roles and duties – as well as a blueprint for separation – on paper is a must.

What to include. A partnership agreement should be part of your business formation, whether you’re governed by a limited liability company, a corporation or a shareholders’ operating agreement. If you didn’t set up a partnership agreement when you got started, do it now. It should include a buy-sell agreement, which establishes financial parameters for how a departing partner’s ownership interest will be bought out by the others. And it should have non-compete and non-solicitation agreements that forbid one partner from starting a rival company and poaching clients or employees from the original business.

Prepare for the unexpected. Business owners don’t want to think about their partners becoming incapacitated, but it happens. That’s why Ferziger recommends providing a mechanism for the partners to compensate someone who leaves due to illness or death. “You work out the methodology of separation and you also fund the liability, determining whether you’ll make a one-time payment or have a number of years to do so,” he says. If the company doesn’t have sufficient cash flow to pay a lump sum to a surviving spouse, life insurance policies are commonly purchased and used for this purpose.

Get appraised. When it comes time to part ways, departing partners are typically paid based on a percentage of the company’s total value. But private firms don’t always have a good idea of what their business is worth because they only get appraised when they’re looking for financing or thinking about selling. It makes sense, even if you’re not in one of those situations, to have a professional business valuation completed about every five years. One detail Ferziger recommends be included in a partnership agreement is whether partners who leave will be compensated based on the company’s value with or without “good will.” That’s the intangible element that represents a company’s relationships with long-time suppliers and customers, above and beyond its physical assets like equipment, real estate and accounts receivable.

Don’t be surprised. Oftentimes, unpleasant facts are unearthed when partnerships break up, from outstanding tax liability to lapsed insurance policies, missing documents or financial irregularities. Spouses and children may complicate matters, given that business partnership interests are often the single largest asset in a family. Make sure that contracts are completed properly, notarized, printed out and stored in secure locations as well as kept on file at your attorney’s offices.

“Dissolving a partnership is not only about separation pains and skeletons, it is about facing a future without the partnership’s income to rely on,” said Paul DeLauro, SVP and manager of wealth planning at City National Bank.

If you are faced with an involuntary dissolution, detailed personal financial planning is essential. Partnership benefits (e.g., life insurance) need to be made portable and personal credit worthiness needs to be protected.

 “Surround yourself with a team of bankers and financial planners who can keep an eye on the critical small stuff, leaving you free to focus on the big picture,” says DeLauro. 

City National Bank, as a matter of policy, does not give tax, accounting, regulatory or legal advice. The effectiveness of the strategies presented in this document will depend on the unique characteristics of your situation and on a number of complex factors. Rules in the areas of law, tax, and accounting are subject to change and open to varying interpretations. The strategies presented in this document were not intended to be used, and cannot be used for the purpose of avoiding any tax penalties that may be imposed. The strategies were not written to support the promotion or marketing to another person of any transaction or matter addressed. Before implementation, you should consult with your other advisors on the tax, accounting and legal implications of the proposed strategies based on your particular circumstances.