When Company Founders (or Their Co-Owners) Have a Falling Out: Plan While the Marriage is Still Good!
Steven J. Keeler
Business and Deal Lawyer “Coach” (for Founders and Owners) and “Quarterback” (for Attorney, CPA, and Financial Teams) to Emerging Growth and Lower-Middle-Market Companies, Their Owners and Investors
Expecting the best of people until they prove me wrong, I always wanted to be a business lawyer and advisor?rather than a litigator.?But I have learned that good people change and disagree and not-so-good people often choose to fight rather than compromise.?So, unfortunately, I cannot avoid the occasional business “divorce” settlement.
Owner death, disability and divorce aren’t the only dreaded “D’s” that can stop a private company in its tracks. Business partner disagreements and deadlocks can take an even heavier toll on business value. People change as a business changes. So, from a company’s start-up phase through growth and possible changes in ownership, the economic, equity transfer and voting rights of not only the founders, but key employee and investor equity holders, should be structured to allow the business to move forward even when all stakeholders don’t agree.
Given the current economic, regulatory, debt and equity markets, and geo-political uncertainty, it is important to note that businesses confronted with customer and supply chain, borrowing and other challenges, and even rapidly evolving business models and strategic (growth or exit) options, may experience increased instances of owner disagreements on the best path forward.
1. Different Multi-Owner Scenarios.
a. “Family” Businesses Not Immuned.?The company may be owned by several family members and/or trusts. Surprisingly (or perhaps not), a high number of business owner disputes which result in litigation occur among family business owners.
b. 50-50 “Partners.”?The company may be owned equally by two founders. Similar to family businesses, 50-50 partnerships present a high risk of future decision making deadlocks that often lead to bad feelings and even litigation. The risk is the same for a company with 3 or more equal founders unless the legal documents provide for majority rule or a tie-breaker vote.
c. Controlling Founder With Minority-Owner “Helpers.”?One founder controls many companies but share minority ownership with family members, key employees or early investors (“friends and family” or “angels”). Minority owners may have limited or no voting rights, but they can make claims against the controlling owner (who may wear owner, director and officer hats), including for breaches of fiduciary duty.
d. VC or PE-Backed Company.?Technology and fast-growth companies often have outside venture capital or private equity “fund,” corporate or family office investors. These companies usually have more clear legal documents defining the economic and voting rights of the owners, reducing the risk of unresolvable owner disputes, but decision-making and respecting the economic rights of “common” and “preferred” equity holders can be less efficient and require attention.
2. Dividing the Pie and the Prenuptial Agreement.
a. Ownership of Shares.?Company ownership should be thoughtfully considered at the beginning and through later changes. “Equal” may not be fair or even wise. Initial and future changes in ownership percentages should be honestly determined and subject to future adjustment based upon owner contributions.
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b. Board and Officers. Ownership percentages are not only about economics, but may also dictate who will be represented on the board and serve as executive officers. Many controlling owners do not appreciate that they may actually benefit from a business and legal standpoint by having a real board with inside and outside or “independent” directors.
c. “Prenuptial” Agreement.?This is really what a stockholder, buy-sell or LLC operating agreement is because it usually addresses things like share transfers, major transactions or even the resolution of “deadlocks”. Striking a good and fair agreement around future transactions does not reflect a lack of trust. To the contrary, it acknowledges that people and their circumstances change and all owners deserve a predictable roadmap for resolving disputes to avoid business interruption. More important, agreeing on dispute resolution or deadlock terms while the relationship is good will save the owners and the company time and money and avoid the damage caused by litigation. Avoiding protracted disputes or litigation protects both the company “goose” and the value of each owner’s equity “eggs.”
3. Paying the Price for Good Legal Counsel.?There are simply too many potential “gotcha’s” in the law to ignore paying for good legal advice. If a good accountant or financial planner is worth their fees, certainly preserving your company equity value is worth a good lawyer’s fees. The lawyer’s role is really 3-fold: (i) ensuring that the desired structure takes advantage of applicable laws that can be changed by an agreement, (ii) crafting organizational documents and owner agreements that comply with those laws and are therefore enforceable, and (iii) ensuring that the company’s “paper” fulfills the business, financial and legal objectives of the company and its owners. This is all true for both companies organized as corporations and those organized as LLCs. I’m a business lawyer because I wanted to plan rather than litigate company growth and ownership. But I cannot overstate the importance of not being cheap about hiring the best counsel to structure a company’s ownership. The “devil” of avoiding bad surprises is in the “detail” that only a good business lawyer can address.
The good news on the law and lawyers is that, if a company is willing to leverage and pay for them, unanticipated “foot faults” can be avoided and the owners’ true objectives can be achieved without fear of any surprise legal claims or attacks. The menu for legal structuring is like renovating a house – companies can use voting and non-voting stock, have different classes of stock with different voting, transfer and (unless the company is an S corporation) economic rights, provide certain owners with “veto” and board representation rights, place restrictions on the rights of employee owners, and protect the controlling owners and board members from claims by other owners. The bottom line: the corporation and LLC laws allow companies to tailor their agreements to their objectives. But this requires a good lawyer.
Although beyond the scope of this discussion, good lawyers can also design owner agreement terms that provide more specific provisions governing owner disputes and deadlocks in decision-making. These include not only dispute resolution procedures but also more “exciting” provisions with names like “Russian roulette,” “Texas shootout” and “forced sale” terms.
4. Side Note on Owner Duties.?While we will not get into the litigation aspects of owner disputes, suffice it to say that there are laws that govern owner, board member and officer behavior to the extent that behavior adversely affects other company owners. So, notwithstanding the best legal documents, owners need to be advised and mindful of the critical importance that they act in a manner that is fair to the company and all owners and which does not expose them to legal claims for breach of “fiduciary” duties. Some of these claims and duties can be reduced with properly drafted legal documents, but to some extent the laws of most states insist that company owners, whether as equity holders, directors or officers, do the right thing, act in good faith and not attempt to enrich themselves at the expense of other owners. Litigation attorneys are always ready to file lawsuits for things like “minority oppression”, “judicial dissolution” and “derivative” suits against director or LLC managers, so smart owners will see to it that their business attorneys take steps to minimize such claims.
5. Take Aways.?So, if private business equity value constitutes a?significant owner asset, pay a lawyer to protect that value. People, whether due to a change of plans or heart, or their personal health or challenges, will usually change. No lawyer or legal document provides a “silver bullet” for every possible unexpected scenario, but a company’s value, to both the current owners and in the eyes of a future buyer, will be enhanced by some planning and documentation around potential owner disagreements or future transactions. We’ve often said that private business owners should focus as much or more on company value as bottom line profits. The quickest and easiest way to enhance company value is to clarify owner economic and voting rights and address them in the unexpected and unfortunate event of an owner falling out. This planning and documentation can be more smoothly handled upon company formation or at any time the company’s ownership is intended to change, and it should be.
Valuation Services Managing Director at Weaver
1 年Fantastic article, Steve Keeler. In the first few months of 2023, I've worked on more "business divorce" planning valuations than I have seen in a very long time. Unclear procedures make difficult partings harder. So much trouble can be avoided if a seasoned attorney prepares robust formation docs.