An outdated or unfunded operating agreement can wreak havoc at the worst time.
Bill along with his 5 partners and their spouses were at the airport, getting ready to depart for their annual week-long planning meeting.
Caval Tool & Machine Inc., the company Bill founded, manufactured subcomponents used in building aircraft engines. It was a very successful business. Each partner owned 12%. As the founder, Bill owned 40%.
It had been a record-breaking year with revenues crossing $24M and pre-tax earnings of $4.3M
The team and their wives were looking forward to their getaway. While results had left the team on a high, operationally the year had been stressful. As they were boarding the plane, the unthinkable happened. Bill had a massive heart attack and unexpectedly passed away in the jetway.
Following the funeral, the remaining partners met to determine a course of action. Their primary focus centered on:
- Buying out Bill’s ownership interest
- Structuring a settlement with Bill’s wife Elaine
- Continuing the company’s operations successfully
After reviewing the operating agreement and its provisions, the team recognized there were major potential problems.
The Main Issues?
- The operating agreement called for a valuation of the company to be completed every other year by an independent valuation firm – In its 13 years of existence, no valuation had ever been conducted.
- The operating agreement called for the company to fund key-man life insurance for each partner. Its purpose was to provide adequate capital to fund a buyout for specified events such as death. No life insurance had ever been purchased for the partners.
- The operating agreement required the creation of a buy-sell agreement specifying the process and procedures of how the buy-out should take place. No buy-out agreement was ever created.
The partners realized that the company didn’t have the cash to pay Elaine a lump sum for Bill’s ownership interest. They had long ago agreed to distribute all the profits annually after retaining enough capital to fund operations.
The Moral of the story – While the team was able to eventually work out a settlement for Elaine’s ownership interest, the process took almost a year and created stress for the remaining partners. Legal costs were significant, a major hit to the company’s bottom line. In addition, the business had to take on substantial new debt to buy out Elaine and continue operations.
The overall impact to the business value was significant and impacted each of the partner’s morale. If the business had followed the T&Cs of their operating agreement, Bill’s unexpected life changing event, while tragic, could have been dealt with more effectively and the problems & disputes it created avoided.