NCBR ARTICLE
When it’s time to turn the car around
By Kevin E. Houchin, Esq.
September 26, 2008 —
Imagine this. You’re two years into owning part of a startup. You’ve invested dozens of hours with your co-founders planning. You’ve invested dozens of nights and weekends away from your family fueling growth. Now things are rolling and it’s obviously time to take things to the next level.
Unfortunately, some of your partners don’t agree. Tension is high. Tempers are flaring. As you’re driving home from another 14-hour day, you wonder what it would cost to just keep on driving.
Can you afford to say, “It’s been good, but I’m leaving to pursue success on my own terms”?
We’ve all asked the question, “What will it cost to leave?” We asked it in our very first job, and we should keep asking in every position we ever hold. Asking the question shows we are still willing and able to grow.
The key to our successful growth is being able to accurately answer the question, but many business owners fail to plan for this eventuality. There will always come a day when you really want to just keep driving and never go back. What will that cost?
Answering this question may be the most important element of business planning. It takes work to write a solid business plan with all the conventional elements of market, management and financial forecasting, but those discussions are relatively easy compared to “What will it cost to keep driving?”
Discussing what happens when someone wants out is charged with emotion, including the fear of failure that nobody wants to bring to the planning table. Avoiding the question can cost huge money when the relationship is strained, so you need to have a plan in the event someone wants out before the multi-million dollar liquidity event materializes.
So, how do you agree on that plan? I’ve helped many startup teams work through the process in three easy steps.
Step 1: Framing the discussion positively
Nobody likes discussing bad scenarios. Fortunately, many good scenarios can frame discussions about what happens if someone wants out. What if someone gets an opportunity to spend two years surfing in New Zealand? What if someone decides to retire early? What if someone gets a chance to move on to a different startup? All these are wonderfully non-threatening stories that you can use to frame your discussion.
Once you’re talking about someone leaving for a reason you all can understand (or even envy), then discussions will go more smoothly, because we can all put ourselves in the position of wanting to move on for something better. At that point we all understand how the other people feel – without anxiety, fear, or blame.
Step 2: Incentive to turn the car around
Now that the topic is framed in a non-threatening, happy story, it’s time to get down to details. Most of the time you have gone into business with other people because they add something to the mix, and losing that person would mean losing a key element of the company’s success plan.
So, you want to give people a good reason to stay. You want to give everyone incentive to turn the car around and come back to work the next day and to work out any differences. That means you’ll want to give a fair, but relatively low, valuation for ownership interest, and you’ll want the company to have the option to pay in one lump sum, or over time.
Valuation of the company is the key. As an owner, you’ll know the financial situation. As a ticked-off owner, you’ll overvalue your contribution to the success of the venture. Without a previously established valuation, or formula to establish valuation, you can’t accurately answer what it will cost to keep driving, and you will very probably underestimate the cost and overestimate the benefit of leaving.
If you decide to go, you and the other owners of the company will likely spend thousands of dollars, maybe even tens or hundreds of thousands of dollars, in legal and accounting fees trying to figure out what your share is worth. That’s incredibly wasteful and easily avoided.
There are numerous ways to value the company, and it’s important to understand that there is no “right” way. The most important thing is that all the owners agree in writing to whatever valuation approach you’ll use.
With brand new startups, I like to use the book value of the company because it’s easy to calculate, objectively measured, fair, and it undervalues each founder’s contribution to the company equally by not accounting for any “goodwill.”
In a new startup, goodwill hasn’t really been established, so the undervaluation acts as an incentive to turn the car around, because if you kept driving you would be leaving what feels like a lot of value on the table. This left-behind value acts as a great incentive to keep key partners in the company instead of taking that surfing sabbatical in New Zealand.
You’ll want to examine the valuation method every year, and after a few years consider adding some amount of goodwill into the formula, but keep it very conservative. Finally, note that if someone is pushing for higher valuation, they just might be thinking of jumping ship.
The second element of this arrangement is giving the company and other owners the option to make the payout in a payment, or over time. Obviously, if someone wants out, it’s best to get them out as cleanly and quickly as possible. Sometimes there isn’t enough cash available from the company or other owners to make a quick buyout, and the buyout has to be completed over time.
I advise giving the company and owners the option to pay 20 percent of the buyout initially, then 20 percent each year over the subsequent four years with a reasonable rate of interest.
This combination of low valuation and extended payment timeline is another powerful incentive to keep essential people in the company.
Step 3: Clear documentation
Just as a good business plan needs to be documented, so does your “what’s it going to cost me” agreement, otherwise known as a “buy-sell” or shareholder agreement. Every owner needs to sign off on the same deal.
When you work with your attorney to craft this document, you will also take into consideration what happens if someone is hurt and can’t work, gets divorced, dies, or does something that requires someone to be expelled from the ownership group. Usually, these factors can be discussed quickly and any uncomfortable feelings these topics generate can be blamed on the lawyer, because you’ll all have agreed to valuation and payout options.
Business planning is a lot of fun. Building a company is a lot of fun. Working with your friends is a lot of fun. Succeed, but plan on the day (and I guarantee it will come) when one of you asks, “What will it cost me to keep driving?” Have an answer ready.
Kevin Houchin is an attorney specializing in business development, intellectual property and marketing for entrepreneurs based in Fort Collins. He will be covering the legal world for the Business Report each quarter, and can be reached at kevin.houchin@houchinlaw.com.