Partners who work together in perfect harmony for decades will eventually cease to be partners. Unless they die together, shareholders of a corporation, members of an LLC, limited or general partners, or co-owners of any other form of business entity, business partners will eventually split up. Plan for it.
A destructive marital dissolution can burn through mountains of money, take an immeasurable toll on both spouses, and harm innocent children. A poorly planned, hot-headed business breakup can cost the owners every dollar they have saved and kill the business that is the subject of their dispute.
For purposes of this article, all business co-owners, under any form of business entity, will be referred to as “partners.”
Most separations between business partners fall into one of the following categories:
The first is the most benign but not infrequent, in which one partner dies, becomes disabled, or must leave the business due to factors beyond his or her control. These are common and provide justification for the necessary discussion that addresses a potential buyout on day one, without putting other partners in a defensive or suspicious state of mind.
The second is a structured buyout with solely business and economic factors in mind: an amicable split. This often happens with experienced partners involved in a “deal,” which does not consume the full-time employment of all of the partners involved, such as a real estate project. The third is an adversarial division that requires negotiation or creative problem solving, often due to inadequate formation or governance of the company, which has placed the partners in a gray area of rights and obligations. These usually involve a higher cost to resolve: in partners’ time, professional services, and the financial drain on the company.
The fourth is a dispute that boils over into litigation or arbitration. This is the most costly and most harmful to the partners and the business. Just like an ugly divorce, one or more partners have long looked forward to the day they could vent their grievances. However, airing these grievances ultimately does little to bring the dispute to closure, and only stirs up more problems.
Each of these four characterizations of a breakup is likely to generate issues to resolve in the valuation of an enterprise, relative control over the business, and the “wrongs” committed by partners. Complex legal issues can arise, such as taxes and the right to conduct ongoing business by each partner. The nature of the breakup will determine which issues receive the most attention.
Things often go awry in every type of separation. Partners’ understandings of the ownership and governance of the business may not be aligned. A distressed widow of a deceased partner might hire an attorney who fires off accusations and criticism of corporate formalities, solely because she is worried that she will not receive the life insurance check.
In a highly adversarial dispute, one or more partners believe they have legitimate claims against each other, and the ability to bulldoze such derelict partner right out of the business for little or no money. This rarely comes to fruition, and often boils over into a dispute with hefty legal bills, harming the business and its owners.
At every stage in the life of a business, the owners should take steps to avoid a destructive partnership breakup. Saving a very modest sum and organizing a business with inadequate corporate legal advice is like building a house without consulting an architect.
The first step toward a clean separation is a clean formation. A corporation should have an odd number of directors, clear delineation of the authority of the officers, and a shareholders agreement that sets forth the rights and obligations of each shareholder and the company, particularly when it comes to a buyout. A business should honor the corporate formalities with voting, authorization of transactions, and changes in ownership.
Most importantly, partners should carefully vet the terms of their shareholders agreement. The agreement must be well-drafted by a corporate attorney and should be fair to all partners. The founders should plan for a financing method to buyout a departing partner.
Following inception, a company should honor the corporate formalities to ensure a properly functioning board of directors and officers, and proper issuance and transfer of shares of stock.
When one realizes that the relationship among owners has soured, he or she should consult a corporate attorney. Ultimately, consulting an attorney before taking steps to further a plan of separation will save the owner money. After all, it costs more to “unscramble an egg.”
The most efficient approach for a partner seeking to split is to adopt a pragmatic and non-accusatory mindset, with the interests of the business of the highest priority. Very few owners who participate in management will cave upon seeing a list of their transgressions (whether their actions demonstrate a failure to exercise the right level of care or loyalty). Most respond defensively and fire off their own list. This leads to an escalation of the dispute, which takes on a life of its own.
An officer of a corporation may be removed by the board of directors, which may trigger a repurchase option on their shares if the company has adopted a shareholders agreement. However, if the agreement is unfair, or the terminated partner feels they have been wrongfully railroaded out of the business they helped build, they are unlikely to roll-over and surrender their shares for what he or she considers an inadequate buyout price.
Compromise and fairness will be necessary to reach a resolution before a dispute may boil over and become destructive.
With proper organization and ongoing governance, the separation between partners might be cleanly unzipped in a relatively efficient way. Without work on the front end, the separation of owners can be like ripping a jacket apart at the seams.
Being sloppy on the front-end or unduly aggressive on the back-end typically backfires and severely harms the business.
6 Business Deal Disasters
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