Exit Agreement for a Company: What is it?
Exit Agreements are agreements between two or more parties relating to the cessation of a professional relationship. Those parties can either be employees and their employer or they can relate to the break-up of a business partnership or joint venture. Regardless of the context, the termination of the professional relationship must be properly regulated. This is achieved through the use of an exit agreement which can be in a general or limited form .
General Agreements: general agreements record every item of terms that relate to the termination of such a professional relationship (as appropriate), and typically include:
Limited Agreements: these document the resolution of a single issue or a limited number of issues. An example of this could be an existing employment arrangement where an employee is required to stay away from work during the notice period so as to prevent the potential transfer or disclosure of commercially sensitive information.
Elements of a Typical Exit Agreement
Exit agreements should typically include a confidentiality clause that provides that the departing employee will keep confidential all information about the company, including business and financial information, intellectual property and trade secrets, post-employment. The agreement will almost certainly need to include some type of non-compete agreement between the employer and employee, restricting the departed employee from working for (or soliciting customers/employees away from) competitors for a period of time post-employment. An exit agreement also may include a financial severance or settlement package between the employer and employee, as well as a general release indicating that the departing employee in exchange for the exit agreement will release the employer from all claims.
Legal Consequences of an Exit Agreement
The legal implications of exit agreements can be quite far-reaching, providing a significant level of protection against wrongful party conduct. Entry into an exit agreement and the consent given by the parties can significantly impact any claim they might have against the other party at common law or under any statutory cause of action because the parties will be bound by the agreement.
The binding nature of the agreement and the clear, relatively unambiguous terms therein can limit the scope of a claim in an inevitable lawsuit or protect against future claims of misconduct. It is often the case that one side has more exposure than the other in an ongoing relationship or later dispute, and the agreement can account for this risk by excluding claims and causes of action that might otherwise be the subject of dispute.
Exit Agreements – Common Practice in Negotiations
Negotiating exit agreements requires both parties to approach the process from a position of mutual interests, so that both sides obtain an agreement that is satisfactory to both. One of the most efficient strategies for accomplishing this is to not discuss the number at an early stage in the process. Often the business owner may have information that would allow him to formulate a price range at which he would be willing to accept for the business. The investor, recognizing this, may attempt to determine where at this range the business owner is willing to transact. If the parties engage on this topic too early in the process, there is a high risk that the business owner will overvalue the company from the purchaser’s perspective or that the purchaser will undervalue the company from the business owner’s perspective. Unless the parties are highly disciplined, this will likely result in the parties deadlocking at an entrenched position, with no likelihood of achieving a deal. As an alternative, both sides can agree to put the number to the side at an early stage in the process, and focus instead on the items that create value or reduce risk to the parties.
Business owners often base their valuation expectations on what they could sell the company to a 3rd party strategic buyer. The reality is that the attractive price you might be able to obtain from a strategic buyer will often be in the range of 2-3x what you would obtain from your partners. For this reason, both sides should keep in mind that what is negotiated in an equity partner buyout is not the price at which the business could sell to a 3rd party but instead the price at which the seller is no longer invested in the company. From the buyer’s perspective, the purchase price should be based on what the business is worth going forward, and not on its past performance. None of this analysis, however, should occur until the parties’ initial focus on the elements that create value for both sides and the items that reduce risk to both sides has been identified and discussed.
A common pitfall to avoid is becoming emotionally attached to specific deal terms. It is understandable that a business owner may have a difficult time letting go of his baby – the company that he has built from the ground up. But there is a fine line between loyalty to one’s company and being unnecessarily obstinate. The founder’s attachment to the company may drive unwillingness to accept a transaction price that is substantially lower than where he thought the company could sell. Alternatively, if a manager is attempting to buy out an equity partner, sometimes he overestimates the risks to the equity holder after his exit and places unrealistic expectations on the deal. By avoiding these pitfalls, the process is more likely to result in a win-win relationship.
Comparison of Different Jurisdictions Regarding Exit Agreements
Exit Agreements are subject to the legal framework in which the relevant business operates, and exit agreements vary significantly across jurisdictions. The purpose of this section is to highlight some of those differences, and some of the relevant issues.
United Kingdom
The UK courts will normally take the view that an English law governed exit agreement is enforceable. They will also normally give effect to it. The circumstances in which a UK court will seek to review a separation agreement in the context of a dispute between members of a group include: (i) until such time as there has been a distribution of the consideration (or a part of it), the transaction has not been fully implemented; (ii) there is some basis other than the agreement (e.g. a substantial change in circumstances or mistake) which that agreement is disputed; (iii) there is some element of coercion or impropriety about the making or implementation of the agreement (see Patriarca v Patriarca [1973] 1 WLR 1305); (iv) the parties did not have the benefit of independent legal advice and one party’s lack of care in entering into the agreement or its lack of understanding of the full import of the agreement may result in it being inequitable to hold the parties to it (see Thomson v Thomson [1994] 2 FCR 389) .
Other jurisdictions
Other jurisdictions could be expected to apply similar principles. For example, the Australian courts have held that the parties to a separation agreement are only entitled to have that agreement enforced if the Court is satisfied that each party has made a free decision to enter into it, on the basis of full knowledge of both the extent of their respective claims against the other and the legal consequences of entering into the agreement (see McKenzie v McKenzie (1976) 45 ALR 134). In relation to a payment agreement, the agreement will not be effective unless supported by consideration (see McDonald v McDonald [2008] FamCA 103, at [83]), in the absence of a statutory provision saying otherwise, although the payments will not be enforceable unless formalised by a consent order or decree of divorce (see Charman v Charman [2004] EWCA Civ 606).
In many jurisdictions, such as Australia, there is specific legislation governing the agreements between former cohabiting or married partners (although quasi marriage is not widely recognised). That legislation may differ from jurisdiction to jurisdiction. In the UK, post-nuptial settlements are only enforceable if they are properly executed trust deeds.
Real-World Examples and Case Studies of Exit Agreements
To illustrate the importance of exit agreements and how to best avoid problems, here are two client case studies demonstrating both bad and good examples.
This client had a very large group of shareholders. There was a cash crunch because of the economic downturn. A distinguished financier summed it up fairly accurately when he told this client: "Everybody is going to give you a lot of great advice, but please listen to me. What you should do is take the cash you have and put it in the bank. It is only going to get worse, and at least you will survive longer." This is very blunt advice, but pretty accurate in this case. A few weeks later, in fact, the client filed a Chapter 11 bankruptcy petition. Several disgruntled former shareholders challenged the bankruptcy petition, saying that there was no reason for the bankruptcy. They based their challenge on a failure to follow the shareholder agreement. After all, Section 12.6 of the shareholder agreement specifically addressed bankruptcy and required certain actions to be taken with respect to members of the company when they filed a bankruptcy petition. In this case, the client had ignored the provisions and did not act. In particular, the client failed to provide the notices required under the shareholder agreement and began receiving challenges. The client unsuccessfully tried to get the court to dismiss the bankruptcy case based on the shareholder agreement. A settlement was eventually entered into both in the bankruptcy court and the state court. The current shareholders took a large haircut, and the former shareholders were still left with a claim.
The second case study also involved a large group of shareholders. The initial set of shareholder agreements were well drafted, and dealt with the situation when a client was purchased in an advantageous way. The former share valuation method allowed for clarity and eliminated problems. The only change in those shareholder agreements was to add an arbitration clause. The arbitration clause was not the cause of the quick resolution, but the client being able to follow the shareholder agreement was, along with the fact the business being purchased was a good business, not just a real estate shell. Although things were bad, the client was not on the brink of financial ruin, and its value could be demonstrated. Because the shareholder agreement was followed, nothing more had to be done. The settlement was immediate, and it was not even necessary to file a petition for appointment of an independent advisor to participate in the valuation process. Unfortunately, many client relationships are not this tidy nor resolved this easily. The lesson we can all learn from these two examples is that when exit agreements are followed, almost any transaction can be made to work for almost any business.
Prospective Developments and the Future of Exit Agreements
The landscape of exit agreements is continually evolving. As the global economic ecosystem transforms, so too do the complexities surrounding intelligent, effective exit strategies. Despite uncertainties in the market, prospective changes typically promise greater transparency and collaboration amongst stakeholders, particularly within cross-border transactions. A prime factor in the ongoing shift in the exit strategy space has been the Covid-19 pandemic. As emergency situations like the pandemic continue to arise, and businesses of all sizes are forced to quickly adapt to ever-shifting local and global priorities, there will be increased pressure for exit agreements to reflect an increasingly dynamic investment environment. This could very well include the emergence of new best practice approaches to data management and the protection of proprietary information. There have also been many economic shifts as a result of the pandemic, and these will have lasting effects on the cost-benefit analysis of exit agreements . Social consciousness is now at the forefront of company operations, with a shifting emphasis on employee health, corporate social responsibility, and solidifying business ethics. Corporate leaders will be increasingly compelled to find solutions that balance their financial well-being with the environmental and social impacts of their decisions. It is also important to consider how international dynamics continue to impact the creation of exit agreements. With an increasing emphasis on the know-your-customer approach under the Canada-Hong Kong AEOI, and resulting global increases in tax transparency (e.g. through breach disclosure), exit agreement developers will respond to this trend in a variety of ways. Designating jurisdictions that require a high level of transparency and information disclosure will provide an opportunity for companies to increase the value of invested capital through derisking.