It is a familiar adage that business partnerships are like marriages, and in many instances, that saying holds true. But, what happens when the forming members of a limited liability company offer a small slice of equity to Mary the head sales rep or Bob the head software engineer? In a perfect world, nothing. But, in a perfect world there would be no need for lawyers, and because we’re here, there must be trouble lurking.
It sometimes happens in the early, “feel-good” days of a new business venture that the founders reward loyal employees with small equity positions. It is an easy thing for a founder to do, and can make good businesss sense if the employee is valuable to a young business unable to pay high salaries. But the honeymoon does not always last. Sometimes a competitor woos Mary or Bob away; other times personality conflicts erode an otherwise good working relationship. This breakdown can lead to a business divorce.
I’ve dealt with these sorts of business divorces in a variety of settings. In one, the majority owners in a company had a falling out with Mary (all names, of course, are fictional), one of their sales reps who did such a stellar job in the first few years that the owners had granted her an equity interest in the company. What otherwise may have been a simple termination of an employment agreement became complicated by the sales rep’s minority interest in the company. The matter was complicated further by the omission from the operating agreement of a provision to deal with the termination of this co-member employee or the recapture of the former employee’s equity.
While it is often true that the parties can agree on a mutually acceptable buy-out, the lack of language in a company’s operating agreement addressing this issue can lead to protracted and costly litigation. In some cases, the costs involved in litigating and evaluating the interest can exceed the value of the interest at issue. That’s not to mention the havoc litigation can wreak on a growing business.
What’s the solution? Good planning. There are a myriad of ways to address the issue in an operating agreement. If you’re thinking of forming a new venture, take a look at my three-part primer on operating agreements available here, here, and here. The message remains the same. A good operating agreement is like a pre-nuptial agreement; regardless of its cost, it can lead to exponential savings down the road.