Breaking Up is Hard to Do: The Business Divorce
by: Arend J. Abel, Attorney
One of the most challenging situations a business and its owners will ever face is when the owners split up. This sort of break-up is what lawyers call a “business divorce,” and it can be every bit as emotionally wrenching as a real divorce. Here are some tips to survive a break-up
Begin with the End in Mind…
The worst cases are the ones where nobody thought to plan for what would happen when the owners split up. Those cases can turn into a free-for-all, with owners locking one another out of the business, calling the police on one another etc. Spoiler: the police will most likely tell both parties it’s a civil matter and that they won’t get involved, unless one of the parties has resorted to actual violence. The situation is improved greatly if the parties have planned for the possibility that the business relationship wouldn’t last forever.
The bare minimum for such planning is a buy-sell agreement, which requires departing owners to sell their interest in the business, requires the remaining owners of the business entity to buy the interest, or both. For a limited liability company (LLC), buy-sell provisions can be included in the operating agreement. Likewise, such provisions can be included in a partnership agreement. If the business is a corporation, the provisions must be in a separate buy-sell agreement.
Good buy-sell provisions will specify when a party must buy or sell, how the parties can exercise their rights under the agreement, a standard and method for pricing the ownership interest, and any credit terms. Often the purchase is done in installments, because the business or other owners may not have the cash for a lump sum payment.
A buy-sell agreement often will prohibit the owners from selling to outsiders without the other owners’ consent, or it may just give the other owners a right of first refusal, allowing them to match the outsider’s price. Other agreements forbid using an ownership interest as security for an owner’s loans, or may be triggered if an owner’s judgment creditor attempts to obtain the ownership interest.
A buy-sell or other agreement should cover all possible scenarios that could affect the business relationship. What if one of the owners wants to stop working, but wants to remain an owner and share profits? What if an owner dies, gets divorced or files bankruptcy? Remaining owners probably will not want to co-own a business with a former owner’s heirs, ex-spouse or bankruptcy trustee. But without a good buy-sell agreement, that is exactly what could happen.
A buy-sell agreement may also prohibit a departing owner from competing with the business for a period of time. For more on restrictions on competition, click here.
While small business owners understandably want to keep legal costs down when forming the business, an up-front investment in good agreements can avoid or mitigate trouble down the road. Because the owners may have differing views or interests concerning these sorts of agreements, each should be represented by a separate lawyer.
The Best Laid Plans …
Even with good agreements in place, disputes can arise. An owner may be dissatisfied with provisions previously agreed and may try to avoid them by alleging the other owner(s) engaged in misconduct, such as improperly taking entity funds, padding expenses, improper moon-lighting, etc. Or the business relationship may have frayed because one or more owners actually did engage in such conduct. An owner may claim wrongful termination as an employee, or may have in fact been wrongly terminated to trigger buy-sell obligations. One party may depart the business with a list of customer contacts and try to “steal” the business away from the corporation.
The legal theories in such disputes can include breach of contract, fraud, securities law violations, racketeering, breach of fiduciary duties and misappropriation of corporate opportunities. These “business torts” are a part of many corporate breakups. For more on what to expect if your business winds up in litigation, click here.
Going to Battle…
When the business starts breaking up, owners should get counsel as soon as possible. An incumbent owner may need advice on how to “fire” a misbehaving owner without violating the law or relevant contracts. An owner being ousted may want to try to block or reverse the ouster or obtain the compensation due under the agreements.
In a competitive situation, it may be necessary to get an early court order to protect the business while the court sorts out who is right. Obtaining such an order requires quickly assembling the relevant documents, witnesses and legal arguments. The party asking for the order must show the order is necessary and that there is a solid chance of winning the overall dispute.
Swords into Plowshares. . .
At some point, one or both owners may conclude that it’s better to reach an agreement than to continue fighting. This is the point at which seasoned trial counsel can be worth their weight in gold. First, counsel will ideally have run the proceedings in a manner that places the client in the best possible bargaining position. Second, experienced counsel is alert for opportunities that might be satisfactory to all parties (such as splitting off different lines of business into separate companies). Third, knowledgeable counsel can give the client a good forecast of what is likely to lie ahead if the dispute is continued, or if an agreement is reached.
Break-ups are a natural and normal part of the business cycle. Without good advance planning and sound counsel, they can also be disruptive, destructive and expensive. But under the right circumstances, they can be handled so that the owners can part amicably, or at least without excessive rancor. If handled well, the business owners may even someday “reconcile.” Contact us for a free consultation.