For many people, starting a new business ranks as one of the most exciting things they will ever do. Visions of large sales, huge profits, and a long period of financial prosperity are on everyone’s mind.
However, even with the best of intentions on everyone’s part, change is inevitable. People may wish to cash out, partners you thought would be honest and reliable turn out not to be, and people can have honest yet irreconcilable disagreements on the best path forward for the company.
In such cases, there may not be a good way for the owners to continue in business together. However, unless companies planned ahead – and most do not – there is frequently no easy way for one party to extricate themselves from a company. In such situations, not only might the owners lose the value of their equity in a business they invested a great deal of time and effort to build, but also the retirement security inherent in owning a business.
Such cases are often referred to as “business divorces.” The term covers a wide range of scenarios from a company being shut down and dissolved and the owners and employees going their separate ways, to the departure of a founder and a dispute over whether employees and customers can follow.
Business divorces are often necessary when an officer or managing member of a company is either failing to comply with required business obligations or is engaging in financial improprieties. Other red flags include companies failing to keep up with normal obligations such as paying employees and vendors, filing tax returns, responding to mandatory audit requests, holding meetings, or filing required materials with the SEC or state agencies. Customers reporting a continuing inability to get service needs addressed, calls returned, or the like should also generate increased attention.
Put simply, if the person in charge refuses to both remedy problems and provide appropriate explanations as to why the problems occurred (which may very well not exist), a business divorce may need to be considered. In today’s legal climate a variety of situations exist in which even if one officer or director does not participate in wrongful activities, knowing of them but not stopping and correcting them can result in personal liability.
Regardless of the cause, without appropriate advance planning business divorces are generally expensive and contentious, and frequently leave all parties in financial and legal positions they do not like.
A Case Study
Consider the following scenario. Two people working at a large technology company come up with a great idea for a new software program that will fill a clear need. They eventually both resign and set up a new corporation in which they each own half of the company, they are each officers, and they are the new company’s only two directors. Because one of the founders is much better at writing software he takes over responsibility for programming and technology issues, while the other, whose background is more grounded in marketing and sales, takes over responsibility for sales, marketing, and general day-to-day business operations.
The company is a success, and quickly gains a Fortune 100 company as a client. The company’s founders are soon able to stop working out of their homes and rent office space. Over the next year the company’s client list expands, and adds large and prestigious clients. The future seems to be bright.
However, the company never seems to generate quite as much income for the founders as it should. Further, the technology partner grows concerned when he begins receiving emails and calls from third parties that the company is failing to, among other things:
• Pay vendors and subcontractors in a timely manner;
• Pay employees and independent contractors in a timely manner;
• Generate and file income tax returns as they become due; and
• Attend to other business obligations in a timely manner.
The technology partner then realizes that despite having been in business for three years, the company has never conducted a board meeting. Efforts to set up a meeting are ineffective, because the sales and marketing partner refuses to attend, and he holds 50 percent of the voting interest, which means the company cannot achieve the quorum necessary to vote on anything. Moreover, the sales and marketing partner generally never seems to be available, and seems always to be on the road on sales calls, at industry conferences, or at marketing events. Worse, as time passes the technology partner has more and more trouble reaching the sales and marketing partner by phone, or even getting responses to emails or text messages.
The final straw comes when the technology partner, who has not taken a vacation during the entire three years the company has been in existence, attends an industry conference, and decides to stay in a luxury hotel as a reward for three years of non-stop work. Upon checking in, the hotel staff extends a warm welcome and indicates they are happy to finally meet the other half of the company’s brain trust. When asked, the staff indicates that the sales and marketing partner is a frequent guest who often throws lavish parties and always tips well.
Upon returning home, the technology partner is able to get a copy of the company’s bank and other financial records, and retains an independent accountant to review the company’s finances. The accountant reports that the sales and marketing partner has been using the company’s bank account as if it was his own to finance a lavish bi-coastal lifestyle complete with parties in Los Angeles, Miami, and the Hamptons, as well as attendance at events such as the Super Bowl and the World Series.
The technology partner reaches a decision that he can no longer continue to do business with the sales and marketing partner. However, the company’s governing documents do not allow the technology partner to simply walk away from ownership responsibilities, which include, among other things, his personal guarantee of the company’s lease and line of credit, as well as his legal responsibility as an officer and director that the company file accurate tax returns when they are due. Similarly the company’s governing documents do not have provisions allowing for one founder to fire the other, force a buyout of shares, or force a sale of shares. Equally problematic, the software, which the technology partner spent three years writing and perfecting, and is the company’s greatest asset, belongs to the company, which means that the technology partner has no right to take the software with him if he leaves.
As a result, the technology partner is left with several choices, none of which are particularly appealing:
• Hire an attorney and sue the sales and marketing partner for breaching duties to the company, and improperly using money. This might solve some monetary issues but not fix the underlying problems.
• Hire an attorney and sue the sales and marketing partner and the company and ask that a third-party receiver be appointed to run the business at least on a temporary basis.
• Hire an attorney and sue the sales and marketing partner asking that the company be dissolved, and the assets sold off to pay the company’s creditors, and if anything is left to be distributed to the owners.
With careful advance planning the technology partner’s options after discovering the wrongdoing described above could be much different. For everyone’s protection, and regardless of whether the company is a corporation, a limited liability company, a limited liability partnership, or any other business entity, the following should be considered well in advance of any problems arising:
• Are there an odd number of directors or other managers to avoid deadlocks? Directors and other managers do not need to be owners, so consideration should be given to having at least one neutral, disinterested director who can act solely in the best interests of the company. Agreements can even be structured such that a neutral director only votes to break deadlocks.
• Is there a provision allowing for one owner to either require that the company buy back his shares and/or allow the company to require an owner to sell their shares back? Parties can agree well in advance on specific wrongdoing that can trigger a forced buyout, as well as a method to select a valuation expert and a valuation methodology the expert should use.
• Are there provisions explaining who gets to use company assets such as customer lists, software, and trade secrets following the departure of a founder or other owner?
• Do all owners, or at least all directors or managers, have equal access to bank accounts and records, accounting records, and the company’s other financial records? One owner not having access to such records can create problems, and having access can be a critical first step in identifying and proving wrongdoing.
• In the event a partner is forced to sell their interests as a result of wrongdoing, are they prohibited from competing against the company for a period of time? Even in states like California, which generally prohibit non-compete agreements, such a provision would likely be enforceable, and give the company a chance to recover from the departing owner’s wrongdoing.
Like their name indicates, business divorces are not fun, and can be destructive to companies. With advance planning, however, protections can be built in to make the process significantly less expensive and destructive.