Issues involving the breakup of partners or shareholders can be more complex than one might consider at first blush. A breakup can occur in various ways, some more civilized than others. The amiable parting of ways with a negotiated settlement, the firing of a minority shareholder, and the lockout by a fellow partner are all situations in which a breakup can lead to unfortunate results. This article focuses on some of the negative effects of partnership dissolutions and recommends a solution that can minimize these problems.
The principal who initiates a breakup usually has several goals in mind:
- Eliminating a source of irritation to him-or herself and possibly the agency;
- Eliminating a cost to the agency which is usually viewed as being unproductive; and
- Regaining control over the future direction of the agency.
Obstacles to achieving these goals that are likely to surface in the near term are:
Litigation: If the departing principal is a shareholder in an agency where no shareholders agreement is in force, he or she may have no option but to file a legal action for dissolution of the agency, to force a negotiation regarding a buyout of his or her equity. As a minority shareholder, the only entitlement to distributions will take the form of salaries or dividends. Without an employment contract, salary stops immediately; commission income may or may not continue, depending on what agreements are in place. A typical agency operating as a corporation does not issue dividends, since they are not tax deductible, but rather distributes excess profits to the principals in the form of salary, bonuses, or perquisites before the fiscal year end. The practical implications are that the remaining agency principals will continue to divide up excess profits unless forced to negotiate with the departing principal over the issue of avoiding a potential corporate dissolution.
Competition: The departing principal may decide that the value of his or her equity stake in the agency is less than the value of accounts which he or she may have an opportunity to take, in light of close client relationships. A principal, because his or her equity stake is less than required by state law to force a dissolution, may decide to make a competitive raid on the agency's book of business because he or she is in a weak position to force a corporate dissolution. There is typically little to stop a departing principal with no enforceable covenant-not-to-compete from proceeding with this course of action. The issue of removing files and expiration lists from the agency is, of course, another matter. The agency could try to force the hand of the departing principal with a restraining order based on the charge of violating his or her fiduciary responsibility. The prospect of being involved in the middle of a legal battle will certainly be unpalatable to the client and may dictate a restrictive course of action.
Staff: The loyalties of employees is another consideration. Departing principals may have strong relationships with other employees who may intend to follow them to a competing organization. Key staff, who may be offered attractive packages to leave, may need to be enticed by increased compensation to remain.
Markets: Divided loyalties may force some of the agency's markets to decide to open another account for the departing partner. This makes it easy to move business using a broker-of-record letter with a newly formed account or with a competitor who uses the same markets.
TWO CASES IN POINT
The following scenarios are based on actual situations involving our firm.
In one case, two partners owned equal shares of an agency which was created through a merger. One partner decided that he could no longer live with the other partner, who had merged with him three years prior. He forbade the ostracized partner from entering the premises, literally locking him out of the office.
The locked-out partner initiated litigation, and arbitration was agreed to. The departing partner had rejected an offer to sell his book to the remaining partner at one times commissions over a period of years. After extensive (and expensive) arbitration the arbitrator awarded the departing partner a payout based upon a revenue multiple of two. Both parties were hurt badly in the process by the costs of litigation as well as the loss of clients in the ensuing confusion.
Another example of a split-up involved three equal partners in a specialty business. All three partners were directors of the agency corporation. One of them was terminated and offered an inconsequential buyout for his shares. He immediately began litigation to force a corporate dissolution. In addition, since the agency was heavily involved in specialty business, he sought out another market to write a competing program. Thus, the remaining partners faced two threats: the loss of business, and a price war on the existing book of business.
The practical financial implications in this case are that any settlement that required the agency to repurchase the shares of the departing principal would be an onerous burden. The only practical ways to fund the ultimate purchase of the departing principal's shares would have been for the remaining principals to borrow the necessary funds or negotiate a settlement based upon a multiyear payout. Either solution would have had a negative impact on the agency's ability to fund future growth. This burden, together with the pressures created by the formation of a new competitor, could conceivably have been heavy enough that it might have been necessary to sell the agency with all involved receiving an equitable portion of the proceeds.
THE BOTTOM LINE: AN OUNCE OF PREVENTION
Settling differences through negotiation is almost always preferable to a power struggle. The dynamics of animosities take on a life of their own that can lead to unexpected damage for all concerned. There is nothing more damaging to client relationships than for clients to find themselves in the middle of a bitter battle. Employees will certainly view the ongoing war with a jaundiced eye, typically assessing responsibility for the carnage and possibly rethinking their long-term plans in light of a heightened sense of insecurity. The partners will inflict and suffer severe damage-financial and emotional-on themselves and each other.
The way to prevent this lose-lose scenario is to recognize the pitfalls of taking precipitous action. Shareholder agreements should always be in place for an orderly dissolution when that is required. Negotiations are always preferable to endless litigation, which harms all the parties involved.