Business Divorce Red Flag #2: Majority Shareholder

“Nearly all men can stand adversity, but if you want to test a man's character, give him power.”

Abraham Lincoln

Introduction

Nothing spells potential business divorce like a multiple partner business in which one owner is a majority shareholder. The key issue that leads to business breakups in this type of corporate structure is that the minority shareholders are liable for the business, but do not have decision making authority to control that liability. For example, many business owners must personally guarantee the company’s building and equipment leases and bank lines of credit. If the majority shareholder is acting in a financially irresponsible way or making bad business decisions without input from the other owners, the minority stakeholders will feel, rightfully so, that their liability and business success is subject to the business judgment of one individual who may or may not be acting in their best interests.

As the next case study demonstrates, majority owned businesses are prime candidates for business divorce.

The Case Study

Jerry and John were law partners. They came to me because they had decided to go their separate ways and needed help mediating their business divorce. 

Jerry was John’s senior by twenty years. Jerry had been a partner at another firm at which John was an associate. When Jerry left the firm, he asked John to join his new practice as a partner. John agreed. Jerry and John owned the new firm 60/40, respectively.  The split was decided based on Jerry’s seniority and, at that time, superior ability to bring in business. Although Jerry owned a majority of the firm, the understanding was that they would make business decisions together.

John was tech savvy.  Prior to joining the firm, he built a website with a blog that was able to land him clients. When he joined the firm, he used the website for the firm’s benefit and spent firm time further developing it, with some content generated by Jerry. The website became a valuable tool to the firm in that a substantial percentage of the firm’s business was generated from it. John, however, was the licensee of the domain name and wrote most of the content.

Jerry and John frequently disagreed about business decisions because Jerry wanted to borrow money from the firm’s credit line to fund his lavish lifestyle. Jerry used the funds for such things as memberships to two golf clubs and a social club, and a luxury car lease.  He would often extend the credit line without having a budget or plan to pay the line down. Clearly, Jerry was living beyond his means. In stark contrast, although John was willing to use the credit line to pay themselves a draw in lean times when necessary, he wanted to limit those payments to make sure the credit line was available for business expenses. At times, Jerry borrowed so much from the credit line that they were unable to pay necessary expenses. John was particularly concerned because Jerry, who was personally overextended, could not pay his share of the debt if the firm defaulted on its credit line. Jerry was not making good on their understanding that he would not make all the business decisions.

Because John was concerned about Jerry’s unilateral business decisions, his personal liability for the credit line, and inability to control Jerry’s out of control spending, John advised Jerry that he was leaving the firm to start his own practice. Jerry, however, convinced John to stay on as a non-equity partner under new terms memorialized in a new partnership agreement. The following were the key terms of the new deal:

·      John relinquished his shares in the firm;

·      Jerry had final decision-making power over the firm’s business decisions;

·      Jerry agreed to remove John from the firm's credit line, but if the bank would not let him, Jerry promised to keep the balance below $100,000;

·      Jerry assumed all of the firm's liabilities and responsibilities, and he and the firm agreed to indemnify John for any personal liability to third parties (primarily the credit line and office lease, which ended in a year). 

·      John would be compensated strictly on a percentage of his originations with a guaranteed minimum salary, which was 25% less than his prior draw; and Jerry agreed to make good on certain payments the firm owed to John in the next eight months; and

·      If John resigned due to the firm’s breach of the agreement, Jerry had a limited time to pay him all he was owed under the agreement or forfeit any ownership claim to the website.

You can guess what came next. Jerry continued his profligate spending and failed to keep the credit line under $100,000 in breach of the agreement. In fact, he did just the opposite. He increased spending and nearly maxed out the $175,000 credit line. In addition, Jerry breached the agreement by failing to make timely payments to John. He was now in the unenviable position of being forced to bear the risk of liability on the lease and credit line (the bank refused to remove John’s personal liability) while no longer receiving the upside of being an equity partner.

On the verge of litigation, they asked me to mediate their dispute. The key issue between them at that juncture was the website because it was the main lead and client generator for both of them. Jonathan’s position was that he individually owned the website because he was the licensee of the domain name and wrote most of the content. Jerry, on the other hand, maintained that the firm owned the website because although it predated the firm, he had contributed to it and Jonathan had used firm time to further develop content including blogs. Neither one of them was budging on relinquishing the website.

I came up with a creative solution: share the website. The home page would be split in two with a vertical line. Each of them would have their new firms on their own half of the page. This way, potential clients could explore both websites and decide for themselves which attorney they wanted to retain. This solution worked perfectly. Jerry and John formed new firms, implemented the website sharing and went their separate ways.  

Summary

The saga of Jerry and John is a good example of why multiple partner businesses in which one owner is a majority shareholder is a red flag for business divorce. Businesses that set themselves up in this manner are asking for trouble, although most owners do not spot the issue until they are knee deep in the business and experiencing its problematic effects. 

The sad thing is, there was an easy solution to prevent the dispute between John and Jerry, as well as others in the same predicament. If John and Jerry would have come to me at the outset of their partnership, I would have recommended that they bifurcate their interests in the firm. That is, the 60/40 split would apply to profit sharing, but I would have recommended a 50/50 split in voting with an appropriate mechanism to deal with deadlocks. That way, Jerry could not make business decisions unless John agreed, or an independent third party decided the issue. This would have prevented Jerry’s spendthrift ways and given John the comfort he needed to be in control of his personal liability.

For a diagnostic questionnaire that will help you determine whether your best clients are at risk for business divorce, text “diagnostic” to (646) 759-1974 or go to www.businessdivorcebook.com