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 properly drafted ownership agreements outweigh any potential benefits. When a new venture is launched, and money is tight, it’s easy to understand why new owners would think that way. New entrepreneurs also assume discussing controversial issues early on will create conflict, rather than prevent or resolve it. When optimism and enthusiasm are high, none of the partners even think to raise and discuss difficult issues that could arise when times get tough (and they always do!). Unfortunately, they’re wrong on both counts.
Business relationships, like personal relationships, can get rocky for a variety of reasons. When disputes break out among the owners, the costs of litigating those disputes without a clear and meaningful ownership agreement will dwarf the cost of preparing agreements that properly and accurately document the owners’ relationship at the outset. Moreover, having to fight internal battles will divert everyone’s attention, time, energy and money away from what should be their primary focus: Running and growing the business!
How Agreements Help Avoid Conflict Among Business Partners
There are five common situations that give rise to disputes among business owners that can, and should, be addressed in an ownership agreement.
Death. Imagine three friends form the Next Big Thing, Inc. (“Big Co.”). Each owns a one-third interest. Robbie and Max are single. Dami is married to his third wife Grace, who Robbie and Max detest. What would happen if Dami unexpectedly died and left his one-third interest to Grace? A good ownership agreement could protect the surviving owners by limiting Grace’s management and voting rights or requiring her to sell the ownership interest back to the company. The agreement could also protect Dami’s interests by requiring the company to repurchase his ownership interest from Grace 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 Grace for Dami’s ownership interest after his death.
Divorce. What if Dami didn’t die but divorced Grace instead? If Dami and Grace live in California, Dami’s ownership interest in Big Co. would be deemed community property, and Grace could be entitled to one-half of it upon divorce. If Grace’s ownership interest is coupled with management rights, it could result in contentious owners’ meetings and family feuds. Also, Dami’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. This won’t end well for anyone.
Disagreements. 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. If the company is structured as a corporation, ultimate authority resides with the board of directors. On a day-to-day basis, however, decisions are made by management appointed by the board, and typically include a President (or Chief Executive Officer), Treasurer (or Chief Financial Officer) and Secretary (or more typically a Chief Operating Officer). As the company grows, these C-level officers will typically delegate further down stream to various vice presidents. 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’s important to the continued operation of the business that someone be able to make a decision. While the board has the final say, subject to its authority, the President will have final say on a day-to-day basis.
To cut costs, many business owners purchase organizational forms online and fill in the blanks without consulting an attorney, which can cause real problems when differences arise. Assume that Robbie and Max each own 50 percent of Big Co. and they buy a partnership agreement online. If the agreement requires a “majority vote” for certain decisions and Robbie and Max can’t agree, the company won’t be able to operate. A good ownership agreement would delegate decisions to the person or persons (i.e., board of directors) best suited to make them or provide a dispute resolution process – like a neutral third party or outside board member – to hear and settle the dispute. Although it can be an awkward conversation, business owners need to decide, and document, how a tie will be broken in order to avoid conflict among business partners.
Distributions. 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? A successful business should result in happy owners, but success often leads to fights over if and how to split the profits. A good ownership agreement will help the owners avoid this result.
Departure. Finally, the agreement should address what happens if someone wants out of the business or if his partners want him out. Can Robbie 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 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 Robbie and Max get the opportunity to sell a controlling interest in Big Co. to a third party, should Dami 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 Robbie and Max be able to “drag along” Dami and force him to sell his shares?
There are no right or wrong answers to these questions. Except perhaps that a 50/50 split of authority or a requirement of unanimous consent is almost always a bad idea. Nevertheless 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.