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Home My Blog Fraud Protection The Business Breakup: Founders Must Consider the Possibility of Divorce

The Business Breakup: Founders Must Consider the Possibility of Divorce

Author: Larry Chester, President

Entrepreneurs, start-ups, and founders of privately held businesses can be excellent at projecting and planning for the success of their business. But in the honeymoon days of a new business, many partners are reluctant to consider what will happen if a dispute arises. To help ensure true success, however, businesses must plan for disagreements and even, in the worst case, the dissolution of the business. To do otherwise could be a costly mistake.

With a little planning on the front end, and a well-considered operating agreement, likely disputes can be avoided or resolved without placing the business in jeopardy. To do so, owners and their attorneys should address likely issues that could lead to disagreement (substantive matters), and how such disagreements will be resolved if they do arise (procedural matters).

Here are a few common substantive and procedural issues that could spell trouble for your fledgling business if not addressed at the outset.

Substantive Matters

  1. Define each partner’s role in the business. Among the most common causes for disagreement is a misunderstanding among partners about their respective roles in, and obligations to, the new businesses. Some partners may provide only capital, while others may be employed full time in the business. Different contributions among owners are often needed for success. However, each owner’s role should be defined in the operating agreement, both in terms of the owners’ legal relationship to each other and the business, and in terms of how each owner will contribute to the business. Doing so avoids disagreements about monetary contributions (e.g., who will be responsible for startup expenses?) and day-to-day responsibilities (e.g., hiring, marketing, and capital raises).
  2. Tie financial obligations and compensation to measurable metrics. New business owners will often agree to use their “best efforts” or to work in “good faith” for the good of the business. But while such agreements are honorable and may in some instances be legally enforceable, they are tailor-made to create disputes among owners. One owner’s idea of “best efforts” might be the other’s idea of sloth. Creating a way to track each owner’s contributions, whether on a time, task or other basis, helps set expectations and avoid disputes. Even better, owners should consider ways to tie compensation to measurable performance metrics. Doing so avoids blowing up the business over small deviations in performance and at the same time incentivizes the owners to meet or even exceed their obligations.
  3. Revisit your operating agreement often. Even the best operating agreements may need to be revised as the business grows and changes. Good agreements will make provisions for interim changes that can be made without overhauling the original design. Owners should re-read their agreements at least annually. Many disputes arise years after the formation of the business. Even if the original agreement was comprehensive and well-tailored to the owners’ initial expectations, those expectations will change as the business does, and the parties’ legal charter should keep pace if internal conflict is to be avoided.

Procedural Matters

  1. Have a deadlock mechanism. An equal partnership (e.g. 50-50) is appealing for many reasons, but if voting rights are divided in the same way, such an arrangement can bring a business to a costly and time-consuming standstill over every disagreement among owners. Owners in such a situation should consider bringing in a new partner or designating a high-ranking officer to break ties on significant decisions.
  2. Consider alternative dispute resolution. No new business owner wants to think about paying third-party professionals to help resolve disputes over the business. But doing so now may save money later. Owners therefore should consider whether disputes will be resolved in court or in a private arbitration, and whether to require informal or formal mediation before a dispute reaches arbitration or court. In some cases, a third-party mediator, who will attempt to aid the parties in reaching a negotiated resolution but who can’t rule in favor of either side or require any result, can help owners to resolve contentious disputes while preserving the business.
  3. Think about the mechanics of a wind-up. Some ownership disputes can’t be resolved and will result in dissolution of the business. Dissolution does not mean, however, that the parties’ hard work and investments must be lost. Detailed provisions for the procedure and responsibilities of the partners or other stand-ins during a wind-up can help to preserve the remaining value of a business on its way out.

As with other relationships, breaking up with your business partner is hard to do. Careful planning can help avoid or reduce the risk of such a break-up.

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