Partner splits most often begin with the company’s success

The owner who came to me with this matter had spent three years trying to persuade his partner. During that time the company grew more slowly than it could have, and so did the value of both owners’ shares. Each of them owned half of the company, so they paid for the dispute in equal parts.

Partner splits more often begin with success than with conflict. Two people set up a company and divide the roles according to what each of them can do. For a few years this division works. Then the company grows, and with it grows the list of skills it demands from both of them. At some point it turns out that one of the partners is keeping up with the company and the other is not. The one who keeps up feels more and more often that he cannot carry out his plans.

The company I am describing operated in the technology sector. I have changed the details so that neither the company nor the parties can be identified. It grew fast, so the gap in skills showed earlier there than elsewhere. The industry matters little here, though. I have seen the same situation in manufacturing, distribution, services and trade, wherever a company grew faster than the people who founded it.

Nobody is to blame here, and that is why the situation is so difficult. There is no event of which one can say that everything started there. What builds up is a feeling that the partners are now merely working side by side. Frustration and tension grow along with it.

How it usually unfolds

The first years are good. Both remember them as a reference point they later try to return to. Their skills complement each other, and decisions are made quickly, because the scale is small and disagreements concern details. The company is small enough for both of them to understand it as a whole.

The divergence begins quietly, along with growth. The company reaches a size at which things count that nobody previously had to look after: management structure, planning, investments an order of magnitude larger than before, hiring people better than oneself. One of the partners learns this faster. The other stays with what he does best, because that is where he feels safe.

Then a difference in attitude to risk appears, and this is the moment when such stories are really decided. The partner who kept up sees in the next investment a risk he can quantify. The one who fell behind sees an amount he cannot assess, and his entire wealth locked in a single company. His caution is rational. He is being asked to approve a decision whose consequences he cannot assess.

From there it is a short step to paralysis. Decisions that require both partners’ consent stop being made, or are made months later in a cut-down version that satisfies each of them only halfway. The partners prepare for talks with each other as they would for negotiations with a counterparty. Someone starts taking notes at management board meetings.

In the final phase the way the partners see each other changes. The partner becomes an obstacle. Only then does the idea of splitting up come up, usually far too late.

One number shows the state of the company best: how many decisions were not made in the past year because the partners could not agree. The number of disputes says less, because disputes can be healthy. At Capital One Advisers we start every conversation about a partner split with this number.

Both are right

The partner who pulls the company forward is right. The company needs decisions it will not make by itself, and with every quarter of delay it loses market share.

The partner who puts on the brakes is also right, although this is said less often. All his wealth is in the company. The company deals with matters he understands less well than he once did. For years it changed at a pace he did not choose. Now he is expected to agree to a risk whose scale he cannot assess. Caution is the only means of protection he has left.

As long as both are looking for someone to blame, the dispute cannot be resolved, because there is no one to blame. A resolution becomes possible only when both accept that the company has started moving faster than one of them wants or is able to.

What each month of delay costs

A dispute between partners has no line of its own in the income statement, so it is easy to overlook. Its cost shows elsewhere. Projects wait months for approval to spend money, and an opportunity to acquire a competitor is lost before the partners reach agreement. Good employees leave, because nobody can tell them where the company is heading. The management team loses the most. Managers learn that it is not worth putting forward ideas, because they will get stuck between the two owners anyway.

This last loss hurts the most. A team that has stopped coming forward with ideas takes years to rebuild, or never recovers, because people leave for companies where someone implements their ideas.

The dispute also shows in the valuation. A paralyzed company earns less than it could for years, and lower profit reduces its valuation. A buyer who notices in due diligence two partners with diverging plans rarely walks away from the deal. He does see, however, that the sellers care above all about splitting up, and he uses this in the negotiations. He lowers the price or makes part of the payment subject to additional conditions.

A company with two partners who have drifted apart is therefore worth less than it would be under the direction of one of them. A buyout makes it possible to recover part of that value before the dispute reduces it even further.

Why a change of roles rarely works

Advisers like to propose a middle-ground solution. The more cautious partner leaves the management board and stays on the supervisory board, and the list of matters requiring his consent shrinks to a few of the most important. On paper this looks good. The conflict is defused, nobody sells shares and nobody pushes anybody out.

In practice it rarely works, for reasons that have little to do with law and finance.

An owner who says out loud that he wants to split up is by then more tired of the other person than of the company. For years he has been holding two conversations at once, one with the market and the other with his partner. The second took more energy and brought in no revenue. The fatigue does not go away when the provisions of the articles of association change, because he still has to talk to the same person, only less often.

There is another side to it. When the owner begins to see that he could run the company alone, he gets a boost of energy he has not had for years. He sees what he would do in the first quarter if he did not have to agree anything with anyone. This prospect outweighs the arguments for compromise, and usually rightly so. An owner who can finally act can change in a year what had stood still for years. He does, however, take on the full risk of mistakes. It also happens that the departing partner was the only person in the company who kept an eye on costs and liquidity, so after the buyout that role has to be handed to someone.

A change of roles works when the more cautious partner himself wants to work less and trusts the other in day-to-day matters. He then gives up his veto over everyday decisions, and the partners agree on a regular dividend. It also works as a transitional stage when both have decided to sell the company together in a few years and want to increase its value in the meantime. When their plans have diverged and one of them is already mentally outside the company, shifting responsibilities postpones the resolution by two years and usually increases the losses on both sides.

The buyout from the point of view of the departing partner

A partner who is offered an exit experiences it as being pushed out of a company he co-founded. This is understandable, but it makes it harder to think about the money.

The arithmetic looks different from what emotions suggest. For a half stake, which gives no control over the company, an outside investor would as a rule pay less than half the value of the whole company. For the partner who stays, the same stake means the end of the deadlock and full control. He has the strongest reason to pay a good price for the shares, and both sides know it. On top of that, a company that stands still because of a dispute loses value every year, and the departing partner loses with it. Exiting at today’s valuation may therefore bring more than exiting in three years, at a valuation he himself helped to drive down.

The departing partner needs above all an independent valuation. The way the price is set also matters. If part of the price is to depend on the company’s future profits, the departing partner will have no influence over those profits, so that part should not be the larger one.

When the price is paid in installments, the payment has to be secured. One way is a registered pledge (zastaw rejestrowy) over the shares sold, entered in a register kept by the court. If payment is not made, the seller can recover the money from those shares and, if the agreement so provides, take them back. A second form of security is the buyer’s notarial submission to enforcement (oświadczenie o poddaniu się egzekucji), which allows an overdue installment to be collected without a lawsuit. The non-compete clause is negotiated separately. A non-compete that is too broad can cost more than the price difference the departing partner was haggling over.

The buyout from the point of view of the partner who stays

The partner who stays has the opposite problem. He has to find the money, and the cash the company needs for growth should stay in it. The most common mistake in such transactions is a buyout paid for out of working capital, that is the cash needed for inventory and for the time spent waiting for customers to pay. Such a buyout solves one problem and creates another, often bigger one, because the company loses liquidity.

The worst option is to pay the partner out quickly from current cash. It is healthier to spread the price over time and secure the payment, or to finance the buyout with debt whose repayment schedule fits what the company can afford. In a partner buyout a bank will lend up to about two times the company’s EBITDA, that is its annual operating profit plus depreciation and amortization. When more is needed, the gap can be filled by private debt, meaning a loan from a debt fund. It costs more than a bank loan. Mezzanine, where the lender also gets a share in the growth of the company’s value, is even more expensive. I wrote about this in my July article on private debt.

Paying out a partner with debt leaves the one who stays with the whole company. Selling a stake to a fund solves the cash problem, but one partner is replaced by another, who has a set exit date. At Capital One Advisers, in such buyouts we first calculate how much debt the company can carry without depleting its working capital.

Next, it has to be decided who will take on the debt. A bank lends to whoever generates the cash, which means the company. The company itself can buy back the departing partner’s shares and redeem them, that is, cancel them. The other partner then becomes the sole owner. The company pays for the redeemed shares out of retained profits. If there is not enough profit, the share capital has to be reduced, followed by a wait of several months during which creditors can object.

Another route is a special purpose vehicle set up only to take the loan and buy the shares. After the deal the two companies are often merged, so that the loan is repaid out of the profits of the operating company. The partner can also buy the shares himself and pay the price in installments out of dividends. He pays tax on the dividends, however, so less is left for the repayments. Each of these routes has different legal consequences and a different tax cost. They have to be checked with a lawyer and a tax adviser before the application goes to the bank.

Who should leave

The difficulty is that there is no one to blame, so there is also no obvious moment to act. That moment has to be set by the partners themselves, and the best basis for it is the number of decisions that were not made in the past year.

It is hardest when both partners want to stay. More often the shares are bought by the one who pulls the company forward, because he is ready to take on the risk of debt. The more cautious partner can also buy out the other and adjust the company’s pace to his own. He has to repay the debt, however, out of the profits of a company that will grow more slowly, so such a buyout works at a low price or with repayment spread over many years.

When the company is worth more than four times EBITDA, half of its value exceeds what a bank will lend for the buyout. Then a fund that buys the departing partner’s shares comes into play, or a joint sale of the whole company. A joint sale ends the dispute fastest, but both partners then give up the company they built at a price reduced by years of paralysis. A debt-financed buyout lets one of them keep the company, although for the next few years a large part of the profit will go to repaying installments. Which of these costs is lower depends above all on how many years of dispute the company already has behind it.

Service: Debt and mezzanine financing