It's always a mess when partners or co-owners of a closely-held company don't document up front how they will buy each other out down the road.

QUESTION.
Two friends and I started a small home-based business in August of 2005. We design, make and sell costume jewelry. We originally started as an LLC, and then gained approval to operate as an s-corporation and filed our taxes as such for 2006. We incorporated online with the boilplate articles of incorporation, but never drew up any further operating agreements or articles. Two of us are doing 95% of the design, manufacture and sales and the third partner, who was supposed to assist with that while managing the books, has fallen very short of her responsibilities and is not pulling her weight. Not only has she not done much in terms of the jewelry, I have had to do a good portion of the bookkeeping as well. Up to this point, she has received a full third of any profits, although she has not technically earned it.

At the end of 2006, we had a meeting in which we discussed this and offered her a few months to improve her performance and value to the company. We explained we would need to eliminate her from the "partnership" if she didn't come up to speed. This past week, we had a review meeting and have mutally agreed to end our 3-way partnership and go forward as a 2-way partnership without her.

We have the following questions we hope you can help us with. In the absence of any partnership agreements, what exactly is she entitled to? We believe she's already earned more than she deserved. Must we pay her one third of our assets? (Our assets basically consist of an inventory of finished goods and raw materials.) Or, is she entitled to one third of the value of our company, and if so, how is that determined? If the latter is so, should we just dissolve this company and start anew so there is no future value to pay her? This is a small business, not yet very profitable, but we have gotten out our initial investments and a small profit as well. It would be a hardship for us to have to pay her anything at this point.

Thank you in advance for any comments you offer us. It is greatly appreciated.

ANSWER.
I'm not sure I have all the facts I need from you. But I will attempt to make some relevant comments just the same. You say you started out as an LLC. Did you have an operating agreement for your LLC which described how the partners would share profits? Did it include any provisions about how to terminate a member (partner)? I suspect it did not.

Then the three of you converted the LLC into a corporation? Or did you choose to just have it taxed as a corporation? Sounds like you actually formed a corporation. But did you ever dissolve the LLC? Or do you have an LLC and a corporation now? And if you have a corporation, then did you issue each other a share of stock to evidence ownership interest held by each?

If your partner is willing to bow out with a fuss, then let her bow out. She doesn't have to get paid for her interest in the business if she chooses not to press the issue. Hopefully the three of you can come to some mutually beneficial arrangement as to what it will take to buy out the third owner. If not, then she technically is entitled to a one third cut in the value of the existing company. The value of the inventory is one thing. But I suspect there is some goodwill that had come into existence.

Consider taking a look at the following book to learn how to value a business. See BUYING AND SELLING A BUSINESS.

If you never issued stock, then how are you going to work that out? Are you going to issue three shares and then take one back? Or are you going to issue just two shares and let the underproducer just leave without ever holding a share?

Typically when you run an LLC you operate much like a partnership. However, when you run a corporation the concept of partnership goes out the window. You become co-owners and you own in the same relationship as the percent of shares you own in the company. It is not a good idea to run a corporation with two owners each owning 50% of the stock. One should own 51% and the other 49%. This way disagreements will not happen - or are less likely to happen.

Try to be as cordial through all this as possible. Any tempers and you'll likely find yourself in court and dealing with legal fees and wasted time. Nobody wants that - especially me.

I think I have answered your question(s). Feel free to send me follow-on questions via email. Good luck! Regards, -Jeff

Jeff Lippincott
SCORE.org Counselor
Princeton, NJ
scoreprinceton @ aol.com
www.scoreprinceton.org
http://www.jlippin.com/