Preplanning for the Unthinkable: Business Divorce

By Brian Haussmann, Partner, Tabet, DiVito & Rothstein LLC

When business partners work together, they do so because they get along great. Maybe they jointly developed the concept for their business. Perhaps they each owned different companies and discovered that their businesses were so compatible that they merged their organizations together. Possibly they were part of the same industry and felt that becoming vertically integrated would provide them with better control over the production and distribution of their products.

There are lots of reasons why people go into business with each other. And when they decide that they can no longer work together, there’s a reason why they call it a Business Divorce. Here are two businesspeople that had great plans to ride off happily into the sunset with each other, but they didn’t make it. Just as two young people, madly in love, who decided to get married, and end up getting divorced.

You can’t see into the future to find out if your dream job with your best friend is doomed to failure, any more than you can predict that your marriage is going to fail. But sometimes they do. So, how do you get practical, and plan ahead for something that you don’t expect to happen? Here are some plans that maybe you should put in place to protect you from the unthinkable.

1. I’m just getting ready to start my company with a partner. We get along great. Why should I put a plan together for a business divorce now?

   Every partner believes during business formation that they will have a good working relationship with their soon-to-be partners. That is, after all, why they are going into business together.

   But it’s a mistake not to give thought to what may happen if your expectations are not met, if a new opportunity arises, or if the business changes in a material way. You need to plan for those possibilities. Change is a given, and the savvy business owner develops a plan for how possible changes will be managed.

   At some point in the life of your business, it is likely to underperform your projections, to experience changes in its business model, to be part of a merger, acquisition, or other corporate transaction, or to suffer the loss of key personnel, to name just a few examples. On day one, a strong business will have an operating agreement or bylaws that address how likely changes will be managed and how disputes will be resolved.

2. How important is it for us to have a buy / sell agreement in addition to an Operating Agreement for our company?

   Very important. One of the biggest questions any new business will need to answer is what will happen if an owner leaves her employment or role with the company or wishes to sell her equity? In other words, under what circumstances will an owner be required or permitted to divest himself of his equity and, relatedly, who will acquire that interest and at what price?

   It is best to determine this at the outset, and then to periodically revisit it to make sure its terms still make sense for the business. Once you decide to have a buy-sell agreement, however, it is equally important that you give careful thought to both the triggers — what will require or permit a partner to invoke the buy-sell agreement, and to the formula for any buyout — how will the departing partner’s equity be valued?

   Mistakes may include permitting transfers of equity to third parties too freely or, on the other end of the spectrum, requiring dissolution of the business if an owner departs or an unpermitted transfer is made. On valuation, owners often select an arbitrary price for buyouts (e.g. book value), without consulting financial experts on the likely impact of the decision.

   Finally, thought should be given to whether a buyout is mandatory or merely permissive, for example in the form of an option or right of first refusal, and to whether the remaining owners or the business itself should purchase the departing partners’ equity.

3. We have a buy / sell agreement. Will that set the ground rules for a business divorce?

   That’s probably the case. A buy / sell agreement is a good idea not just in the event of a business divorce, but for all the potential reasons why your partner may no longer be able to serve actively in the company, including disability, incapacity, or death. In the event of the death of your partner, this would readily address the process of your buying out or working with your partner’s heirs.

4. We are a startup looking to enter into our first operating agreement. What are some of the things that we should be thinking about in drafting our operating agreement?

While there are many things to consider, you should at a minimum consider the following big questions:

• How will the company be managed? Will all partners have management authority, or only certain partners? Are there big decisions (e.g. borrowing large amounts, entering into leases, mergers and acquisitions) that should require everyone’s consent?
• What capital will partners be required to contribute? How will capital contributions be treated?
• How will partners be compensated? Will compensation be tied to performance, or will partners simply receive a percentage of net profits? Can that change, and if so, when, and how?
• Will partners work exclusively in the business, or will they be permitted to work outside of it as well? Consider separate employment agreements for key personnel.
• Will new partners be permitted? If so, what will be required for admission?
• Will a partner be permitted to transfer his / her interest to a third-party? On what terms?
• How will partners vote on major decisions? If there is a deadlock on a major decision, how will the partners resolve it?
• What will happen if there is a major dispute among partners that threatens the viability of the business? How will those matters be resolved?

These are some ways that you can protect yourself from a dramatic, negative change in the business that you jointly own with your partner. But, whether you have had the foresight to plan ahead for the unthinkable or not, there are times that it just happens.

What can you look forward to then? What are some of the reasons or actions that are going to keep you up at night after those long years of working together? Come back for Part Two in our next monthly newsletter.

Read Part Two now: Dealing with the Unthinkable: Business Divorce