Closely Held Businesses: Agreements and Disagreements
At one time or another there will be an end to your business. When you started your business, you should have developed an exit strategy, but sometimes things don’t go as planned. The business may end happily in a merger or acquisition and sometimes less happily by dissolution or bankruptcy.
Without clear guidelines at the outside, you will find that extricating yourself from your partners may be costly. A business divorce may have similar acrimony to a family divorce. In a family divorce, there is the combustible combination of kids and money. In a business divorce, the business partners undoubtedly will also argue about money—and will contend for control over their business, which for founders, can be like an extension of their families. The disputes among partners are not easy disputes. And business divorces like their family counterparts have numerous moving parts in various areas of the law such as business organizations, contracts, unfair trade practices, employment law and trade secrets.
The small business owner needs to start planning for the end from the first visit to the business’ startup lawyer. At Rosten Law, we spend much of our time with startups in the formation process, negotiating operating agreements for limited liability companies (LLCs) and shareholder agreements for corporations.
This article summarizes some of the considerations you should keep in mind when discussing with your small business lawyer what steps you and your partners should take to minimize the risk of a messy divorce with your partners down the line. In the next article, we will discuss what are the consequences and possible outcomes of a business divorce. When we use the term partners, we mean members in a LLC, shareholders in a corporation, and partners in a partnership. We focus primarily on LLCs and corporations as those are the most common forms of business organization that startups are using today.
Related article: Forming a New Business: Corporations vs LLCs
Preventive medicine
The best preventive medicine from getting a business divorce is to select good partners. One seasoned veteran summarizes it concisely in this recent post: “Choosing the right partners is critical.” And he suggests that when you have made a mistake in selecting your partners, “be prepared to walk.”
Besides selecting a good partner, there are ways to reduce the uncertainty of business divorces. Just like a prenuptial, you can and should enter into an agreement before the business is formed. If your startup is a LLC, then you should negotiate carefully the terms of the operating agreement; and if your startup is a corporation, you should have a shareholder agreement.
When there is relative agreement between your partners and you at the beginning of your business, it will be much easier to come to an agreement rather than trying to reach an agreement in the throes of a divorce. You and your partners will likely spend some time talking with each other and your startup lawyer about the terms of the agreement. When you and your business partners decide to call it quits and start to squabble about the business, you should have already have clear guidelines in place on the mechanism by which to resolve your differences.
Related: Negotiating LLC Operating Agreements
Most common areas of discord
If you are running a small business with partners, you know that issues arise every day between you and your partners. Some of these issues are issue to resolve; some not so easy. But it is a basic tenet of business planning that you and your partners should be on the same page when managing and governing the business. Despite the best intentions of the partners, however, there are some issues that prove divisive and are not subject to easy resolution without assistance from third parties. And some of these issues break small businesses apart.
These disputes fall into similar fact patterns. To illustrate, let’s take an example of a business divorce case in Illinois. Partner A alleged that Partner B breached his fiduciary duty to the corporation by engaging in a competing business. Partner B allegedly used the services of the company’s employees in the conduct of the competing business without reimbursing the company. Partner B also allegedly misused and misappropriated corporate funds by paying himself unauthorized sales commissions and unearned overtime. Monotronics Corp. v. Baylor, 107 Ill. App. 3d 14 (Ill.App. 2 Dist., 1982) Most business divorce cases follow a pattern, and generally fall within the following categories of disagreement between or among partners.
- Distributions. There are many disagreements over the timing and amount of distributions from the business. Your business has shown a profit and one partner wants the company to disburse some of the money. Another partner wants to keep the money in the business to support organic growth of the business. The most contentious issue occurs when there is a substantial operating profit and the company has not made any distributions. If the business is a pass-through entity, such as a S corp or general partnership, the partners may have to pay substantial taxes on money they have not received.
- Partner compensation. The majority owner of the business is receiving a salary or guaranteed payment from the small business that eats up most of the profit from the business. And let’s say the market salary for that position in other companies is only half of what the majority owner is paying him or herself. You can understand why this situation may cause friction to other partners.
- Personal expenses. Another sure-fire method to eat up the monies available for distribution is for one of the partners to spend the company’s money on arguably personal expenses. The majority owner is using that company credit card for lots of personal expenses or otherwise using the company’s assets.
- Lazy partner. A similar issue arises especially when there are two partners and they have an understanding that they will each devote an equal amount of time to the business. One of the partners in the business is a laggard and the other partner wants to figure out a way to get rid of the lazy partner. The flip side of this issue is when one of the partners excludes the other partner from a meaningful role in the operations of the company.
- Competing business. One partner decides to set up a competing business, not telling the other partner of his or her intentions, or contrary to a non-compete agreement. In this scenario, often one partner may accuse another partner of taking something of value from the company such as customer lists or computer code.
- Information access and disclosure. The majority owner does not want to provide information to a partner or to an investor regarding the operations of the company. Sometimes there may be the concern that the other partners may want the information to set up a competing business. Sometimes a partner will simply help him or herself to information without the other partner’s knowledge or consent. Or the majority owners do not want to hold meetings at which they will discuss and disclose information about the business. Just because you have an ownership share of a business may or may not mean that you have access to information. And even if you do, you may have a restrictive covenant or confidentiality agreement that prohibits the partners from using or disclosing the information.
These are only some of the many fact patterns that arise in small businesses, but the ones we have cited are the most frequent ones that we see.
Theories of recovery
Problems can and do arise and sometimes even good legal documents may not deter litigious partners from resorting to a lawsuit. In Lansing v. George Carroll & GW Carroll VI LLC, 71 F. Supp. 3d 765 (N.D. Ill., 2014), a business divorce between two individuals, there were extensive governing agreements between the partners and they had already invoked the “buy/sell” provisions of the agreements, but still ended up in an acrimonious lawsuit.
The disgruntled partner has a whole arsenal of legal theories to proceed against the other partners or the company. These include the following: 1) breach of contract; 2) breach of fiduciary duty; 3) minority oppression. Once one partner decides to move forward, then he or she must consider whether the claims are direct or derivative, depending on who suffered the alleged harm, the partner or the company, and who would receive the benefit of any recovery or other remedy. In a closely held company, some states permit a partner to assert a derivative claim as a direct claim.
In a breach of contract case, the aggrieved partner will rely on the terms and conditions of an operating agreement in the case of a LLC or a shareholder agreement or sometimes a buy/sell agreement for a corporation. Other common breach of contract actions may include breach of a non-competition clause or non-solicitation covenant either as a separate agreement or part of one of these governing agreements or as part of an employment agreement.
In a breach of a fiduciary duty action, the partner claims that each of the partners has a “fiduciary duty” to one another or to the business. If there is a breach, the aggrieved party may recover damages. A fiduciary duty may require one person to act for the other’s benefit and to avoid self-dealing or conflicts of interests. This fiduciary duty may in certain circumstances require that a corporate office or director not take a business opportunity for him or herself and defer to the business. Majority shareholders may be held liable for breach of fiduciary duty if they try to “freeze out” minority shareholders to continue the company for their own benefit. Viener v. Jacobs, 834 A. 2d 546, 556 (Pa. Super. 2003).
In a case of alleged minority oppression, a minority partner may complain where a majority shareholder stands to benefit from his decisions as a controlling stockholder. The majority’s action should be “intrinsically fair” to the minority interest. The policy of the company to deny benefits to the minority owners would be incompatible with this fairness standard. Orchard v. Covelli, 590 F. Supp. 1548, 1556 (W.D. Pa. 1984).
Business divorces can be divisive
Business divorces can be a nasty business. In some cases, they can break apart long term friendships or divide families who may be partners in the business. And they can drag on and on to the detriment of the business and cost huge sums in attorneys’ fees. Take this recent case of Wichansky v. Zowine (D. Ariz., 2016), in which the parties fought “the bitterest of business divorces, and this is only one of several lawsuits between them.” The court noted that the complaint was 100 pages long with 548 paragraphs of allegations and the parties had already filed 71 motions. That could not be good for business. In a continuation of this article, we will discuss what are the critical determinative factors in a business divorce and possible outcomes if the parties are unable to resolve their differences themselves, or through an alternative dispute resolution mechanism such as mediation or arbitration.