As the New Year approaches, people begin to think about money making ventures and perhaps starting a new business to see where that great idea can take them. Despite the positivity in aiming for business success, from a relational standpoint, people enter closely-held businesses in the same manner as they enter marriage: optimistically and often ill-prepared. As a result, many business people fail to enter into appropriate ownership agreements that could protect them if the business fails, a partner dies, or the owners decide to part ways.
Many entrepreneurs believe the legal fees and hassle needed to obtain such agreements outweigh any potential benefits and assume discussing controversial issues early on will create conflict, rather than prevent or resolve it. But, like many marriages, business relationships can get rocky, and when disputes break out among the business owners, the costs of litigating those disputes without a clear and meaningful ownership agreement can dwarf the cost of having documented the relationship correctly at the outset.
Moreover, having to fight internal battles can divert everyone’s attention away from what should be the primary focus—running the business. There are five common situations that give rise to disputes among business owners that can, and should, be addressed in an ownership agreement.
No one wants to think about because it is unlikely to happen; unfortunately, death and incapacity are more common than you would think. Imagine three brothers form DroneSales, LLC, and each owns a one-third interest. Al and Bob are single, and Carl is married to his third wife Darlene, who Al and Bob detest. What would happen if Carl unexpectedly died and left his one-third interest to Darlene? Or if Carl didn’t outright die, but was in a car accident and is in a comma or incapacitated? A good ownership agreement could protect the surviving brothers, for example, by limiting Darlene’s management and voting rights or requiring her to sell the ownership interest back to the company. The agreement could also protect Carl’s interests, for example, by requiring the company to repurchase his ownership interest from Darlene for its fair value and detailing how the fair value will be determined.
The ownership agreement could also authorize the company to purchase key man insurance, which could be used to compensate Darlene for Carl’s ownership interest after his death. If incapacitated, perhaps the ownership agreement can mandate the remaining members to temporarily suspend Carl’s interest (from voting, etc.) until he is back at capacity to exercise the rights afforded and avoid his wife or a third party exercising his rights in the company? The parties need to think about this situation before it is too late and it interferes with running the business as they originally intended.
What if Carl didn’t die but divorced Darlene instead? What if the laws make Carl’s ownership interest in DroneSales to be deemed community property, and Darlene could be entitled to one-half of it upon divorce?
If Darlene’s ownership interest is coupled with management rights, it could result in contentious owners’ meetings and family feuds. Also, Carl’s ownership of the company would be decreased from 33 percent to approximately 16.5 percent, which could affect the balance of power the parties originally bargained for in terms of voting, decision making, profits/distributions, etc.
The owners of a new business also need to decide who will be the ultimate decision-maker, and then give that person the power to make decisions. Often people go into business with the desire to do everything by consensus or unanimous consent. But there will inevitably be situations in which the parties can’t agree, and it is important to the continued operation of the business that someone be able to make a decision. To cut costs, many business owners purchase corporate documents and organizational forms online and fill in the blanks without consulting an attorney, which can be problematic because the provisions in those documents are not narrowly tailored to fit the type of business and relationships of the parties.
Assume that Al and Bob each own 50% of DroneSales and they buy an operating agreement online. If the agreement requires a “majority vote” for certain decisions and Al and Bob can’t agree, the company won’t be able to operate. A good ownership agreement would delegate decisions to the person best suited to make them or provide a dispute resolution process, such as a neutral third party to hear and settle the dispute, or allow a neutral third party to break ties and deadlocks in voting. Although it can be an awkward conversation, business owners need to decide, and document, how a tie will be broken before a dispute occurs.
Business owners also need to talk about, and document, how they will get paid. Will one or more of the owners draw a salary, and if so, what are the job requirements and time commitments? If down the road someone isn’t pulling his or her weight or becomes physically unable to do so, how will that be addressed? If the owners will receive profit distributions from the company with no specific work obligations, how will those be calculated, and if mandatory, when will they be paid – what is the frequency? A successful business should result in happy owners, but success often leads to fights over if and how to split the profits, especially when certain members are claiming or demanding higher amounts than others.
Finally, the agreement should address what happens if someone wants out of the business or if the partners want a member out. Can Bob sell his shares to a third party and, if so, what are the purchaser’s management rights? Should the company or other owners have a right to purchase the interest or shares first? If owners can only sell their shares back to the company or to other owners, the agreement should set out a mechanism to value the departing owner’s interests. The owners should also decide if they want to include “drag along” or “tag along” rights. In other words, if Al and Bob get the opportunity to sell a controlling interest in DroneSales to a third party, should Carl have the right to “tag along” and get the same deal for his shares? Or if the third party wants to buy the entire business, should Al and Bob be able to “drag along” Carl and force him to sell his shares? No party should be denied the reasonable value of their investment; hence, playing your cards right in drafting proper provisions at the start can help avoid litigation and legal problems that can stall a sale or major fundamental change the owners really want, but cannot engage in because one member is stalling that process.
Ultimately, there are no right or wrong answers to these questions (except, arguably, a 50/50 split of authority or a requirement of unanimous consent is almost always a bad idea); moreover, there are plenty more items to consider beyond the aforementioned items, but the prospective business partners should have a meaningful discussion about these issues and then craft an ownership agreement that clearly lays out how they will be resolved.
This publication/newsletter is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer. Any views expressed herein are those of the author and not necessarily those of the law firm.