“From a relational standpoint, people enter closely-held businesses in the same manner as they enter marriage: optimistically and ill-prepared.” As a result, 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 such agreements outweigh any potential benefits and assume discussing controversial issues early on will create conflict, rather than prevent or resolve it. But, like many marriages, business relationships can get rocky, and when disputes break out among the business owners, the costs of litigating those disputes without a clear and meaningful ownership agreement can dwarf the cost of having documented the relationship correctly at the outset. Moreover, having to fight internal battles can divert everyone’s attention away from what should be the primary focus—running the business.
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 brothers form ABC Health Care, and each owns a one-third interest. Al and Bob are single, and Carl is married to his third wife Darlene, who Al and Bob detest. What would happen if Carl unexpectedly died and left his one-third interest to Darlene? A good ownership agreement could protect the surviving brothers, for example, by limiting Darlene’s management and voting rights or requiring her to sell the ownership interest back to the company. The agreement could also protect Carl’s interests, for example, by requiring the company to repurchase his ownership interest from Darlene 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 Darlene for Carl’s ownership interest after his death.
Divorce – What if Carl didn’t die but divorced Darlene instead? If Carl and Darlene live in Texas, Carl’s ownership interest in ABC Health Care would be deemed community property, and Darlene could be entitled to one-half of it upon divorce. If Darlene’s ownership interest is coupled with management rights, it could result in contentious owners’ meetings and family feuds. Also, Carl’s ownership of the company would be decreased from 33 percent to approximately 16½ percent, which could affect the balance of power the parties originally bargained for.
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. 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 is important to the continued operation of the business that someone be able to make a decision.
To cut costs, many business owners purchase organizational forms online and fill in the blanks without consulting an attorney. which can be problematic. Assume that Al and Bob each own 50% of ABC Health Care and they buy a partnership agreement online. If the agreement requires a “majority vote” for certain decisions and Al and Bob can’t agree, the company won’t be able to operate. A good ownership agreement would delegate decisions to the person best suited to make them or provide a dispute resolution process, such as a neutral third party 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 before a dispute occurs.
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.
Departure—Finally, the agreement should address what happens if someone wants out of the business or if his partners want him out. Can Bob 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 Al and Bob get the opportunity to sell a controlling interest in ABC Health Care to a third party, should Carl 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 Al and Bob be able to “drag along” Carl and force him to sell his shares?
There are no right or wrong answers to these questions (except, in our opinion, a 50/50 split of authority or a requirement of unanimous consent is almost always a bad idea), but 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.