Exit payments to partners and members

As firms move away from the traditional ‘capital in equals capital out’ partnership or LLP model, the financial arrangements on ceasing to be a partner or member of an LLP have become increasingly complex, can involve sizeable sums, and are fertile ground for disputes.

The statutory position

In the absence of provision made in a constitutional document, the financial position of an outgoing partner or member will be governed by the Partnership Act 1890 (“the 1890 Act”) and Limited Liability Partnerships Act 2000 (“the LLP Act”). Outgoing partners or members will be entitled to their shares of profit but in relation to capital, the statutory position is almost certainly undesirable.

Under the 1890 Act, an outgoing partner from a partnership will be entitled to the capital value of their share as at the date of exit, and may either apply to the court for a just and equitable winding up, where the partner does not already have a default right to wind up the partnership in the complete absence of an agreement between the partners.

Or, if it is agreed that the business continues notwithstanding the partner’s exit, the outgoing partner has an implied right to require the other partners to acquire the partnership share. The continuing partners’ hands are forced here, not to mention the uncertainty around valuation methodology.

The position under the LLP Act is detrimental to the outgoing member of an LLP. There is no express statutory right to a return of capital, so the widely held view is that the LLP interest falls away on cessation of membership, and the capital value accrues to the continuing members pro rata to their equity interests inter se. In effect, the outgoing member has no right to payment for the capital interest in the LLP.

Standard provisions

For these, and many other reasons, therefore, it is essential that partners and members ensure that comprehensive constitutional agreements are in place. Most partnership and LLP agreements will provide for the following payments to be made to an outgoing partner or member:

• (i) A share of the profits for the accounting year in which the exit occurs, net of any advance drawing made
• (ii) A share of the profits allocated to the partner or member but undrawn in respect of prior accounting years
• (iii) Repayment of any loans or amounts due to the outgoing partner or member from the partnership or LLP
• (iv) Share of retained profits from the tax reserves insofar as they are not applied on behalf of the partner or member
• (v) The balance standing to the capital account of the partner or member.

Value extraction

It is, however, increasingly common for partners and members to seek to extract “value”, often in respect of the goodwill, from the business on an exit. Bespoke arrangements are typically drafted to meet clients’ specific requirements, but by way of example, the following are commonly found in more sophisticated documents:

• The soft-landing

Often firms with difficult succession planning issues will want to include “soft-landing” provisions, giving retiring partners or members a continuing, often tapering, share of profits for a period of years following their retirement. This therefore removes the glut at the top of equity and allows new partners or members to join the partnership or LLP and develop the business for the next generation.

• Anti-embarrassment provisions

Again, these are useful for succession planning purposes, but are also appropriate for partners or members wishing to exit, but where a sale of the business is in prospect. Founder partners and members of a successful business will almost certainly want recognition of their achievement.

Anti-embarrassment provisions provide for former partners or members to participate in the proceeds of sale of the business or interests. Such provisions may have a duration of two or three years and therefore the valuation methodology will be important. Is it to be fixed at the date of exit, or will it reflect the continuing success of the business, albeit on a tapering basis?

• Synthetic goodwill payments

Some partners or members will want to extract value on an exit. Valuation methodology should be clear here. If the fair market value is to be used, an agreed calculation should be included in the document, and it is recommended that the valuation process be undertaken by an independent accountant or valuer appointed by both parties, whose determination shall be final and binding.

Commonly, payments might be calculated by reference to the average of the outgoing partner or member’s share of the net profits for the preceding, say, three years.

Alternatively, the partnership or LLP agreement may contain an entitlement to a fixed sum. Whilst this has the benefit of certainty, the parties may not feel that this is a true reflection of the “value” of the business interest.

Final considerations

The agreed financial arrangements on exit will depend upon the position of the partners and nature of the business, and the inherent flexibility in the partnership or LLP model allows for bespoke arrangements to be easily accommodated. For some-fixed share junior partners, the basic provisions will suffice, whereas for founder partners, or participants in a highly successful business, value extraction in some form will be key.

One final issue for continuing partners or members will be the timing of payments. A large exit payment may have adverse cashflow implications for the business, on the other hand, where the payment obligation is outstanding for a significant period of time, this liability may prove unacceptable for new or ambitious partners or members wishing to maximise their profit shares.

Exit arrangements should also be reconsidered from time to time, particularly where the number of partners or members grow, or the financial circumstances of the business change for the better, or indeed, for the worse.

Failure to reach an agreement that is fair to both the exiting party, and the continuing participants, will invariably lead to a financially and reputationally damaging dispute. Under the guidance of a good professional advisor, however, businesses will be able to navigate these complex discussions.