Business Divorce and Fiduciary Duties
Proper Planning to Avoid Disputes Between Business Owners
If you enter into a marriage with your own assets, it is considered reasonable and practical for you to ask your future spouse to enter into a premarital agreement even though you both hope and plan for a happy and healthy marriage.
It also seems reasonable and practical for entrepreneurs coming together to launch a new business venture to enter into the appropriate legal agreements – such as a limited liability company operating agreement or corporate bylaws – before jumping head-first into a business relationship.
However, all too often in the process of starting up a promising business venture, owners skip the critical step of carefully considering the difficult topics to discuss, such as what happens in the case of:
- An unexpected death or incapacity of an owner
- Significant life change, such as personal divorce or bankruptcy, of an owner
- Separation of an owner, along with the company’s confidential and proprietary information or client list
- Disagreement between business owners
- Financial difficulties in the company
Whether this is due to a small (or non-existent) legal budget, optimism (e.g. “we get along great and agree on everything!”), a lack of understanding of the purpose of the legal documents, or a narrow focus on the “business side” of things, the result is the same – a significant increase in the cost and complexity of resolving any disputes that could arise in the future.
By consulting with legal counsel at the outset of your business, not only will you end up with proper legal documents in place, but you will gain a better understanding of why those legal documents are important. In other words, the simple act of considering the difficult issues with your legal counsel will help you appreciate the (general) purpose of these agreements and how the various provisions work together to help you avoid (or, if all else fails, resolve) disputes among your business partners.
With that in mind, here is a quick overview of several of the most important purposes of your company’s governing documents (such as a limited liability company operating agreement or corporate bylaws):
- Limited Liability Protections: One of the primary reasons for creating a new business entity is to take advantage of the “limited liability” protections that come with it. At the same time, one of the primary reasons that plaintiffs are able to “pierce the corporate veil” (i.e. remove these limited liability protections and pursue you personally) is failing to have (or comply with your) governing documents. Examples of actions that potentially expose owners to personal liability includes “commingling” assets (i.e. not properly separating personal and business assets) or failing to comply with “corporate formalities” (i.e. maintaining records and properly documenting important decisions). Taking the time to understand the purpose of, and take proactive efforts to comply with, your governing documents is critical to maintaining these liability protections for the benefit of you and the company.
- Ownership Percentages: Many entrepreneurs will simply agree to split ownership 50-50 with a new business partner, because it seems easy and logical. However, depending on each person’s role and contributions to the company, this ownership structure might not be appropriate and could lead to tension or disputes later on. Thus, it is important to consider (and discuss) what each person brings to the table at the outset, as well as what each person will contribute as the company grows. Too often, we see companies that start with 50-50 ownership, but quickly realize that one person is providing 80% of the value (and only receiving 50% of the profits or potential upside). At the same time, even if you identify this upfront and agree to an 80-20 split, it is crucial for the 20% owner to understand the issues and risks associated with being a “minority owner” (i.e. lack of control or ability to make decisions).
- Profit Sharing: As with ownership percentages, co-owners will often just split the company’s profits 50-50 (or otherwise based on ownership percentages). However, there are many reasons why co-owners might want to split them up in a different way – e.g. one owner is a passive investor while the other is actively involved. Regardless, it is important to have this discussion (and then properly document your agreement) upfront to avoid any issues or confusion about how this works.
- Management and Decision-Making Rights: Anyone who has run their own business is likely familiar with all of the decisions that must be made just to keep the doors open. And anyone who has had a business partner is likely familiar with how frustrating it can be to make decisions if you have not properly outlined the management and decision-making rights. This is important in any business, but is perhaps most important in a 50-50 partnership (or any other situation where one person or group is unable to make decisions without the buy-in or support of the other person or group).
- Adding and Removing Owners: As any business grows, it is possible that the current owners will want to add another owner (whether they have expertise in a certain area or they are investing cash to help the company grow) or remove an existing owner (whether due to irreconcilable differences or simply because someone is moving on to other adventures). Also, due to the inescapability of death, it is also important to address what happens when an owner dies or becomes incapacitated. Regardless of the reason for adding or removing an owner, this process will be infinitely easier if your governing documents include clear and detailed procedures for how to handle these situations.
There are many other reasons why governing documents are important – both at the outset and throughout your company’s operations – but the running theme could be summed up as “clarifying expectations”.
Regardless of whether you are a majority or minority owner, or each partner owns an equal share, it is very important for you to understand how the various provisions of your governing documents affect your ownership (and financial) interest in the company so you can plan accordingly.
By having proper legal documents in place at the outset – and complying with the procedures and requirements in those documents – you are much more likely to enjoy the type of happy and healthy business relationship avoids major disruptions in your business (and personal life and finances) – and focus on running (and growing) your business.
Join Catalyst Law attorneys David Rocker and Nate Funk on Tuesday, May 26th at 3:00 pm (PT) for a (free) live webinar on “Business Divorce and Fiduciary Duties – Navigating Disputes between Business Owners”.
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