Before starting a partnership, every founder needs to face the uncomfortable question: What happens to the company when a partner leaves? A clear “buy-out” provision in the partnership agreement, designed to preemptively structure a partner’s exit, secures the company’s financial future and stability. This proactive step ensures that, regardless of the reason — a voluntary split or an involuntary event like disability — the terms are already set, protecting the continuity and value of the mutual business.
Without a contractual regulation on this matter, the partners may be forced to dissolve the company and distribute the remaining assets among all other partners. Another possible scenario is transferring the departing share to an outsider whom the founders do not know and with whom they would not run a business. Most critically, a lack of agreement between partners on the price of the departing partner’s share can lead to a deadlock, leaving them with no choice but to incur excessive expenses to resolve it.
Suppose founders choose a limited liability company (the “LLC”). In that case, the “buy-out” provision can be included in the LLC operating agreement, which serves as the partnership agreement for the LLC members and governs the partnership relationship. If your company is a corporation, the “buy-out” clause is usually a part of a shareholder agreement that governs the partnership relationship among shareholders.
The components of the “buy-out” provision normally include the following:
The Reasons a Partner May Leave the Company
1. Death or disability
2. Partner’s bankruptcy
3. Starting a new venture and resignation
4. Offer from a third party to buy the partner’s share
5. Losing the company’s share in divorce
6. Foreclosure on the partner’s share in the company if the share was used to secure the partner’s debt
Who Can Buy a Departing Partner’s Share
1. The company itself
2. One or more other partners in the company
3. Third party.
Frequently, the “buy-out” clause states that if a partner intends to sell her share, the other partners have the right of first refusal. This means that the other partners must be offered the opportunity to buy the share before any third party does. If the partners decline, third parties may buy the departing partner’s share. Even more often, the partnership agreement combines the right of first refusal belonging to the company itself and the partners: if the company refuses to buy the share, then the partners can buy it, and as a third and final step, if the partners don’t buy it, then the third party can purchase it. This way, the founders can restrict outsiders from buying shares.
The right of first refusal plays a critical role in the foreclosure procedure on a partner’s debt secured by a share in the company. It also plays an important role in divorce settlements when the partner’s spouse receives the right to share in the company. In these events, the “buy-out” clause can save founders from having to transfer the divorcing partner’s share to the other spouse, who may or may not have any knowledge of the business.
Price of the Share of the Departing Partner
Since it would be unfair to force the departing partner to accept a fixed price determined in the partnership agreement long before they decide to sell, the companies usually either provide a formula to calculate the fair value of the share in the future or agree to hire a qualified appraiser to determine that price.
A thoughtfully constructed “buy-out” provision is the primary protective measure for any partnership. This clause sets clear expectations regarding the reason for a partner’s departure, dictates to whom the share can be transferred, and establishes the procedure for calculating the share price. By formalizing these terms upfront, founders eliminate the risk of undesired dissolution or the critical threat of working with incompatible outsiders.