When Agreements End in Litigation
We speak and hear thousands of words a day – so much so that we forget just how powerful words can be, whether spoken or written. I was recently involved in a litigation case that involved some very valuable words. In fact, millions of dollars were riding on the accurate application of one sentence.
Nuances of Operating Agreements
As a business owner, there are many documents that justify your time and attention. One of these important documents details the agreements among the owners of the entity. This document is known as an operating agreement or a partnership agreement, depending upon the type of business entity.
In this case, the subject company was a limited liability company (LLC), which utilized an operating agreement. One of the articles within this operating agreement was entitled Mandatory Offer on Withdrawal. This article was intended to outline the purchase price the remaining owner(s) would pay a withdrawing owner if (s)he decided to leave the company.
It is not uncommon to find a variety of methods to determine the exit value of an ownership interest within these types of agreements. These methods can include a specified dollar amount, an agreed-upon formula, or even wording directing an independent party to appraise the business and determine its value. The important thing to remember about these documents is that they are simply agreements between the parties who sign them, meaning that the terms within the document aren’t required to be equitable, they simply must be agreed upon.
Evaluating Operating Agreements
Within the operating agreement of the LLC in this case, the sentence read as follows:
“On the withdrawal of any Member, the remaining Member(s) shall purchase the shares of the withdrawn Member on a pro-rata basis.”
At first glance, the sentence seems standard and straightforward. However, once you carefully consider what is written, its meaning becomes much more convoluted.
In this case, the company consisted of two owners divided at 65 percent and 35 percent. The 35-percent owner decided he wanted to sell his ownership interest and exit the company based upon provisions in the operating agreement.
The operating agreement defined the purchase price to be paid based upon five times the average of the two highest years of net earnings, over the immediately preceding five-year period. Based upon this formula, each member calculated the purchase price and arrived at two distinctly different numbers. So how is it that this simple formula could yield such drastic differences?
Discrepancy in Calculations
The discrepancy between the two calculations came down to two distinct differences of opinion as follows:
Purchase Price – Though the formula to calculate purchase price is clearly defined, the 65-percent owner confused purchase price with company value. Company value is based upon the price an independent party would be willing to pay for an ownership interest in a company based upon the cash flow produced and the risk associated with achieving those cash flows.
Though a similar method is utilized here by multiplying the net income by five, if the resulting purchase price accurately reflected the company’s fair market value, it would only be by happenstance.
The stated purchase price, however, is a price that is based upon an agreement between parties and doesn’t attempt to calculate the fair market value of the company. It is typically based upon a rudimentary formula agreed upon by the parties and may be utilized to buy out exiting members. In essence, the owners within this company decided to forego having a professional appraiser determine the value at the date of withdrawal, and instead utilize a predetermined formula. But the “purchase price” wasn’t the only disagreement – it was also in the use of the term pro-rata basis.
Pro-Rata Basis – In the context of this case, millions of dollars hinged on the use and application of the term pro-rata basis. As mentioned earlier, the agreement states that on the withdrawal of any Member, the remaining Member(s) shall purchase the shares of the withdrawn Member on a pro-rata basis.
The 65-percent owner thought this sentence meant that the purchase price should be determined utilizing the defined formula and then be multiplied by the withdrawing member’s ownership percentage.
However, the operating agreement clearly defined purchase price and pro-rata related to how the remaining members would purchase the exiting member’s interest.
So rather than the exiting member receiving 35 percent of the calculated purchase price, this clause directed the remaining member(s) in the company to split the total purchase price based upon their pro-rata ownership interest. The pro-rata basis was applicable to the buyer(s) rather than the seller. If there happened to be two or more remaining members buying out the departing member, those remaining members would allocate the buyout price based upon their ownership percentages.
Takeaway
In the end, the jury ruled that the amount due to the withdrawing member was clearly stated in the operating agreement. In light of the case’s events, it is important to remember that company documents should be drawn carefully in collaboration with the owners to be governed by the agreements. In addition, having an accountant review these documents can bolster their effectiveness and avoid unexpected outcomes in future circumstances. Additionally, buyout and other provisions should be reviewed periodically and potentially modified as the business matures and the ownership structure changes. Failure to consider these important factors could result in expensive surprises.
Our team has extensive knowledge and experience in managing litigation cases like this one, and many others like it. For more information on how our team can help with your litigation issues, reach out to your Windham Brannon advisor or contact Matt Stelzman.