United States: Avoid A Bitter End For Your Business

Last Updated: July 1 2013
Article by Rebecca A. Isaacs

You've always dreamed of starting your own business—find the perfect partner, rent a great space, produce beautiful widgets together. If your business plan sounds a bit like a wedding fantasy, that's no coincidence. And while most marriages don't need or involve a prenup, the opposite is true when two or more entrepreneurs get together in a business venture.

When deciding to go into business together to follow a dream, not enough people do a reality check before tying the knot. You've got a unique product or service to offer, you've raised capital, what more can you need? You need to establish the terms of your ultimate separation with your partner (or partners). You may not be thinking of this on the front end, but even if your business succeeds, your original organization may not. The priorities in your business may change over time, you may take on new partners, and each of the original owners will want out at some point. The goal should be to manage your expectations with your business partner(s) now so that you don't have to do it in a crunch.

Get it in writing while the going is good

Think of your written business agreement as a prenuptial agreement. Yes, you hope you'll never break up. But most business ventures do, and it's much easier to agree on the separation terms while you are still in the honeymoon stage with your business partner. Write everything down now when you have the best opportunity for compromise.

What if you're already in business?

Even if you're already in business, it's not too late to write out your operating agreement. The point is to solidify everything in writing while you're getting along no matter where you are in your business lifecycle. You may have inherited this business, or purchased an existing one. Perhaps you recently merged with another company. Or your business has grown in a new direction and you see some of the big-picture issues in a new light. Anytime is a good time to put your affairs in order.

Writing out terms may bring existing conflicts to light, but clearer operating agreements will ultimately strengthen your business relationship, lowering the odds that you (or your respective heirs) will end up fighting with a partner in the case of an untimely break-up. By planning ahead, you'll rest easier knowing that you and your partner(s) have already written out the foundation of a healthy business exit plan—to end either the business or your collaboration on good terms.

Prepare for the worst, hope for the best

First, you and your business partner should envision every possible scenario that might lead one of you to leave the business. Depending on the nature of your relationship, this type of hypothetical discussion might come naturally for you. But it's not unusual for this to be a difficult conversation, even between the most collegial business partners, and if you have more than one co-owner, plan on having more than one conversation about the various scenarios.

Don't dance around the hard stuff. Talk about fights and how you'll handle disagreements. Talk about who is in charge. Consider the situations in which you'd take on a new partner. Imagine illness, bankruptcy (personal or business), economic and even natural disasters and their possible effects on your business. Be sure to discuss what happens when one of the owners dies. Does that person's share or duties in the company pass onto the spouse or children? You could end up in business with different people than you began with or intended, including people who do not understand the business and could jeopardize your security.

Get counseling, especially if you're really married

It's even more complicated if your business partner is also your partner in life. Whether your business partner is your spouse, significant other, relative, or friend, or is a strictly professional co-owner, you will want to acknowledge the personal dynamics and legal dimensions. You may want to seek out a trusted but neutral third party to guide and mediate these preliminary, informal discussions, much like premarital counseling.

At this stage, you do not have to hash out every detail or make any decisions. Just identify what you would value in your "ideal" business divorce—if there is such a thing—and decide together on the questions and issues that you'd like to discuss with your legal counsel.

Make it legal

This is important: Retain separate legal counsel to represent and protect your individual interests. It's not a sign that you distrust your partner, nor is it necessarily adversarial. It's just good practice with any contract. Besides your own lawyers, a third independent counsel may be retained to work with your separate attorneys to write the agreements.

Legal fees are costly, but typically it costs more to argue business dissolution with no prior agreement than to properly set up operating agreements that give explicit instructions upon dissolution. If you don't pay now to formalize your agreements, you'll likely pay a lot more later.

Steps to take, decisions to make

To prompt your discussions and help you prepare, we've compiled a few of the common questions that you'll address with your business partner and lawyers when drawing up the agreement. Keep in mind that these issues may vary with the type of business and entity.

  1. Who has the ability to expel an owner?

    • Can it be done with or without cause?
    • What percentage of the vote is necessary to expel?
  2. How will the purchase price be determined?

    • Formula
    • Capital account
    • Professional valuation
  3. Will the exiting partner or shareholder (or heirs) be paid cash upon exit, or over time?

    • If over time, will he or she have creditor rights?
    • Will the exiting partner/shareholder be required to provide a release
      from claims once payment is made?
  4. Will there be a split and distribution of property?

    • How is this determined?
    • Is there intellectual property that can or cannot be split? How will
      this be distributed?
    • Are there property rights of the exiting owner that should be
      considered, such as titles, deeds, registrations, warranties, etc.?
  5. Should there be a non-compete agreement?
  6. Will the company or other owners indemnify the exiting owner from existing debts or guarantees?
  7. What is the exiting owner's ability to access or use confidential information owned by the company?

    • Customer lists
    • Intellectual/proprietary property and information
  8. Timing – when is the best time to split or liquidate?

    • Are there obligations that have to be fulfilled before an owner can
      separate or a liquidation can occur?
    • Who will be responsible for these obligations, and when will they be
  9. Arbitration/Mediation – Consider a clause to avoid large legal fees in the event of disagreements.
  10. Consider the tax consequences of a sale of stock or buyout/liquidation.
  11. How will the other owner's/owners' voting rights be affected?

    • Votes cancelled
    • Votes reallocated
  12. How will negative capital accounts be rectified?

    • Deficit restoration clause
    • Allocation of additional income or reduction of expenses
  13. Consider life insurance policies on owners.

Renew your vows

Revisit the operating agreement often to ensure that it still represents the understanding and expectations of the owners. Things change over time. The agreement that was perfect for a new business may be an ill fit for a mature business. You or one of your partners may want a status change, or one person may want to move or slowly ease into retirement. As in marriage, roles change over time.

Your operating agreement may seem like it's preparing for the worst-case scenario. But it can also lay the groundwork for a happy ending. Ideally, your work on a business prenup will lead the way for your business succession plan so that you and your partner can exit the business when you each wish to, and do it on amicable, mutual terms.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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