People working together as part of a farming operation and/or on a piece of land they manage together should have a written agreement on how they will work together. These agreements are often called governance documents, covering questions about who makes decisions and in what way. Who has access to the bank account? Who can sign on behalf of all of us, and the one we’re going to talk about in more depth now–how does a person get out of this agreement if it no longer serves their needs?
Lawyers often warn about the difficult ‘Ds’ in business partnerships. The words that start with ‘d’ that you need to know how to deal with are death, disability, default, disinterest, disagreement, and divorce. So many bad things can happen when you are working with others! A business partner could die unexpectedly, get hurt and unable to work, become deeply in debt, slowly become more interested in a different career, develop a vision for the business that is not aligned with other members, or get divorced and need to reshuffle their life. Any of these things could very easily lead a member of a business to either be pushed out or decide to leave the business.
Exiting a business and exiting shared ownership of land are two different beasts. We will deal with governance documents and exit plans first before turning toward how business changes might impact the ownership of land.
The Cost of a Business Exit: Valuation & Financial Planning
In an ideal world, if a business owner wanted to leave a shared business, there would be a reserve of funds available to repurchase the departing owner’s share. Additionally, there would be an easy, fair way to establish the value of the company so that the departing owner’s share could be easily calculated without any contention. For many small businesses, either one or both of these circumstances are absent when a business partner needs or wants to depart the business.
Typically, the most contentious aspect of a transfer of business ownership is the value of a person’s stake in the company, which relies on the value of the company itself. One common and straightforward formula for determining the value of a business is to assign a fair market value to all of the company’s assets and subtract any liabilities the company has. This is often called asset-based valuation.
However, a company can have intangible assets as well. A business can have value based on its reputation in the community. Are there annual profits? If so, the value of the business will increase. However, if the company is operating with no or negative profits, the value of the business would decrease. Businesses with reputation-based value typically have been around for a long time and have strong brand recognition. Departing members in the early phases of a business are less likely to get any compensation for their efforts to build the company’s reputation.
A governance document should choose a formula for valuing the business before the business gets off the ground. This way, there isn’t a scramble to come to a consensus at the point when someone is anxious to leave the company quickly.
There are many valuation techniques to choose from, and they vary in complexity. Some formulas may incorporate the sales price of similar businesses in your area, a projection of future earnings, or how much has been invested into the business by owners and stakeholders. It can be difficult to use peer-based analysis for small farms as many don’t get sold, and even if they do, the information on those sales is difficult to obtain. Formulas based on income and projections of what income may be in the future are based on a lot of assumptions and require a stable income to work. And finally, the amount of investments into the farm will likely, for the first decade of the farm’s existence, be skewed when compared to the accruing profits. It is likely that no single formula will work perfectly for a small farm business. Nonetheless, mathematical formulas can make what promises to be somewhat of an emotional process a little more objective. Having a third-party professional who understands accounting will be immensely beneficial as well.
Farmers already working with an accountant should ask that professional for advice on a valuation formula. Another resource is the federal Small Business Administration, which runs a network of free small business mentors through their SCORE Business mentoring. These mentorship programs are available nationwide (or meetings can be virtual). Though the executives that staff the SCORE program will likely not be versed in the economics of agriculture, they will be experienced in valuing businesses and providing general small business advice.
Some valuation formulas are favored by people looking to buy into the business (this person would likely be looking for a lower valuation) or those exiting the business (would want a higher valuation). Choosing a valuation method at the outset of the business formation will decrease potential conflict when one partner needs to exit. Some experts suggest using multiple methods to establish the business value to see the range of possible values. Those outcomes can then be averaged unless one method is clearly more suitable for the farm’s circumstances.
Valuing the business is an important step, but it is only one part of the cost of a business exit. What about the actual funds to support a transfer in ownership? The money to support the transition has to come from somewhere.
One option when a business partner is leaving voluntarily is to negotiate a “buy-out” price. This will vary greatly from business to business depending on the length of the exiting member’s time in the business, the business’ stability, the departing farmer’s investments into the business, and the business valuation. The buy-out cost will need to come from the business’ savings or by having a new business partner “buy in” to the business. The investment required to “buy in” to the business can be used to pay the departing business owner their share.
If an existing business partner is negotiating for a “buy-out,” the length of time that they must be paid back must also be negotiated. Many small businesses with low cash flow will want low payments for a long time in order to manage the “buy-out.” This method might allow the business to stay afloat, but will be less than ideal for the departing member.
There is a danger that one business partner leaving the business will force the sale of business assets in order to buy the departing member out of the business. Negotiations will need to consider how the business can fare under the pressure of paying for a departing member. On the other hand, business partners who never made capital contributions to the business and are leaving while the business is still getting established will not have a strong argument for a sizable buy-out.
A strong business exit plan would include budgeting or saving for a transfer of ownership. To ward off the risk of losing a business partner to death, Businesses can also purchase life insurance policies for business owners. If the business is the beneficiary and pays the premiums, the death benefits received would be tax-free. These benefits can then be used to fund a buyout or keep the business running in the face of losing an income earner.
Governance Document Protections
A resilient governance document will include agreements on how to transfer business interests and will do so in a way that protects the business against unwanted transfers. Businesses will want to protect against having a section on transfers of business interests to protect the business against unwanted sales of ownership interests. To illustrate one possible governance document structure, we will look at how a limited liability company’s Operating Agreement could structure transfers.
Generally, an Operating Agreement will have an entire section dedicated to transfers. Not all transfers will be equal, though. Some transfers will occur because of voluntary withdrawals, others will be agreed upon, but there are some that will be limited in their effectiveness. There are protective mechanisms added to these Operating Agreements that keep unwanted transfers from changing the direction of the business. These mechanisms can include an agreement that no member can leave and simply demand immediate repayment of their capital contribution, limiting voting rights on incoming members, and rights of first refusal, which would allow members who are staying the right to purchase the outgoing member’s share before it is sold to a stranger.
Voluntary withdrawals need to be limited so that they don’t force a business to liquidate in order to compensate an outgoing member. An important clause in an Operating Agreement would be one that could, for example, say:
Except as otherwise provided in this Agreement, no Member shall have the right to receive any return of any Capital Contribution or to receive a repayment of any balance in the Member’s capital account.
Without a provision like this, many state laws would allow an LLC member to withdraw from the LLC upon giving notice to the members and require that the withdrawing member get their capital contribution back. This, of course, could become a problem if the farm operation does not have the cash flow to pay back the value of the capital contributed or would prefer to keep it invested in the company. Instead of a guaranteed right to withdraw, members operating under an agreement with this clause would have to agree on the terms of their withdrawal, including when and how a withdrawing person is to be paid out for their percentage interest.
There may be times when a departing business member is going to be replaced with an incoming member. Operating Agreements that are protective of the business may include a clause that limits when and how that incoming member can get full membership rights, such as this one:
The transferee shall not be admitted as a Member unless approved by unanimous consent of the Members who are not transferring their Interests.
This protects against outgoing members selling their business share to someone who will not work well with the remaining business partners.
Often, how membership rights are controlled is through the extension or retention of voting rights. If someone who is transferring into the business is approved unanimously (or by whatever method the members decide) to become a Member, then they get all benefits of membership–rights to distribution of a share of the profits and a right to vote on business decisions. If the new member hasn’t been properly approved, then they only have the right to get distributions and not vote. Without rights to vote, there is no say in when distributions are given, or otherwise in other management decisions. This division of financial and voting rights makes partial membership much less appealing, and so allows the members who are staying a degree of control over the ongoing management of the business.
Another common legal protection for management changes is the right of first refusal. These clauses require that before any member sells their share, they must first present the terms of the proposed sale to the other Members of the business and give them a timeframe in which they must decide to purchase the share or pass on the opportunity. Of course, in order to take advantage of this protection, the Members who are staying must be able to pay for the share that the outgoing member wants to sell.