This article was written for Commerce Magazine NJ and first appeared here.
When the principals of a newly formed partnership, closely held corporation, or limited liability company (LLC) launch their venture together, it is often accomplished without proper documentation. Ideally, that business grows far beyond the wildest expectations of the parties when they launched, years prior. But this is often the point where "trouble in paradise" develops among the principals. Analogous to the circumstances underlying a divorce between marital partners, over time the principals may develop differences in how to best manage and operate this business. This leads to a rude awakening when they are told that their written agreement fails to provide what is needed to ensure a smooth and swift resolution of disputes. And, at times, those differences and disputes cannot be peacefully resolved, and th principals need to go their separate ways.
Over the course of decades, New Jersey's Legislature has incrementally adopted a comprehensive, but complex, patchwork of laws designed to set what can best be described as the "rules of the game" for business participants. Over that same period, New Jersey's courts have been asked to provide judicial interpretation of those laws, and they have delivered scores of cases that reveal the broad contours of the "rules of the game." This article provides a primer of the various considerations for principals of closely held businesses should a breakup be inevitable.
The Common Forms of Closely Held Businesses
Closely held businesses usually take one or more common forms, and the laws applicable to each can differ substantially. A general partnership is a type of business organization in which two or more individuals pool money, skills, and other resources. Likewise, they share profit and loss in accordance with the terms of their written or oral agreement. A partnership is assumed to exist where the participants in an enterprise agree to share the associated risks and rewards proportionately. Many people are surprised to learn that they have been operating as "partners" with someone with whom they have enjoyed an informal business relationship that turned into a genuine opportunity.
A corporation is an entity that is separate and distinct from its owners and is owned by them as stockholders/shareholders. As such, upon formation of that legal entity and registration with the state, stockholders share in profits and losses generated through the company's operations. A limited liability company or LLC is a business that allows one or more persons to organize in such a way that their liability is limited to their investment in the company. The members are able to enjoy the single taxation feature of a partnership or sole-proprietorship firm, and they can decide upon the distribution of profits and tax benefits.
It is sometimes the case that businesses operate using more than one of these legal forms for different aspects of their business (i.e., use of a corporation for an operating company, and use of the LLC form for the real estate). Many clients are surprised to learn that one can claim ownership in an LLC or corporation even without the issuance of a formal stock or member certificate, provided there is some indicia of ownership such as a course of dealing or corroborated promises of ownership and reliance thereon.
Duties of the Business "Owner"
In each scenario outlined above, business owners, no matter the business structure, owe duties to one another while the relationship is ongoing. Also, they have duties during any wind down of the business. The nature and types of duties are far too broad to outline here. Simply put, you can become personally liable if you are not careful how you treat your fellow business owners. For example, New Jersey has a comprehensive set of laws applicable to each form of ownership which protects participants from oppression or other illegal activity by other participants. Even where a business has been operating for years without a formal partnership/shareholder/LLC operating agreement, the law may impute legal obligations to the participants of that business.
Some "Do's" and "Don't's" Before Heading for the Exit
Before heading for the exit there are some considerations to keep front of mind. First, hire competent counsel with experience in this practice area. Do not hire a general practitioner who "just dabbles" in this area. You will end up paying more in the end. When hiring counsel, ask for the attorney's actual experience litigating these cases. Second, organize your files, and pay close attention to any agreements you have, and take care to focus on files demonstrating all aspects of the financial performance of the company and the value of your interest. Remember that as a shareholder, member, or partner in a business, you have broad rights to access and review all of the business's records and documents. Third, begin to think about your next phase, but do not take formal action toward a new venture such as forming a new (competing) company, reaching out to existing clients, or downloading extensive client data, until you meet with competent counsel and understand your rights and obligations.
Fourth, and very importantly, honor the written agreement(s) you
do have. Continue to follow the corporate formalities that exist,
such as holding meetings and voting on actions to be taken by the
business. Resist the urge to act precipitously by unilaterally
taking control of the business by firing a co-member, stopping
their salary and benefits, or locking them out of the business
without the advice of counsel. It is often the case that an
agreement between principals contains a notice and cure provision.
Moreover, taking such "self-help" can have disastrous
consequences in litigation that ensues thereafter. Indeed,
depending upon the situation, your breach could relieve the other
party of performance altogether, including in certain situations
possibly relieving that person of a requirement to provide capital
to the business or freeing that person of any limitation on their
ability to compete against the business.
CLEAN Exit: Negotiating the Departure and Buyout
When trouble develops and it is no longer possible to work together, the principals of a closely held business should strive for a clean exit. Such an exit may occur through a decision of the parties or as the result of resolution in court. Whether leaving on your own or being bought out, one must strive to clearly define the obligations on both sides. Here are some of the key considerations for negotiating and documenting a "CLEAN" exit:
- Clearly define the financial obligations on both sides and the compensation to be paid in the future to the departing principal. The sum to be paid, how it is to be characterized, and when, must be articulated and set in writing. If the paying party is providing security for the payment of its obligation, attention should also be paid to ensure that the security can be acted upon if necessary. For instance, in a closely held LLC or corporation, it may be possible to negotiate an agreement where the remaining members/shareholders pledge their member interests/shares as collateral for payment. You will want to take the necessary steps to ensure that such a pledge is enforceable and the security interest in those interests/shares is perfected (i.e., subject to no other claims). If at all possible, address all contingencies and leave no wiggle room;
- Liability issues must be squarely addressed before departure. If you are the departing principal, it is going to be important that you obtain a release from the entity(ies) and co-principals for past and future liability stemming from the company operations. It is also important to be removed from any financial obligations the company may owe to lenders, bonding companies, factors, mortgages, etc., and to extinguish any personal guarantees you may have given on behalf of the business (such as to a landlord or a lender);
- Enforceability is key. What good is a buyout agreement if you do not have a strong mechanism to get paid in the event of a default? If you are the departing principal, you will want to take care to delink the payor's payment obligation from any obligations by the departing member (i.e.., confidentiality or non-disparagement), lest you create the temptation for the payor to falsely claim a breach in order to cut off future payments. There are a multitude of strategies to streamline enforcement, including alternative dispute resolution rather than litigation to keep the legal fees and costs down, and a provision awarding attorneys' fees and costs to the victor so that the parties are incentivized to be well-behaved;
- Accounting. Behind every good trial lawyer is strong accounting support, and our firm routinely calls upon several trusted accounting firms (CIANJ members) in this process. You must ensure that you have received proper accounting advice concerning the transaction with three principal goals in mind: 1) create the maximum financial benefit to you; 2) be sure that you have properly valued your ownership interest; and c) ensure that you have considered all tax ramifications of the transaction and structured the transaction appropriately to minimize any tax liability; and
- No trap doors. We are often amazed to see buyout agreements come across our desk that fail to pre-emptively address potential traps for the departing principal, resulting in litigation down the road. One example that comes to mind is a failure to address whether there are lingering "shareholder loans" on the books of the company. In the negotiations for a buyout, one must fully vet and understand the disposition of those loans, as the forgiveness of such a loan can create tax consequences to the departing principal. Also, if you are the party being bought out, you will want to accelerate the payment of financial obligations if there is a change in control of the company after the signing of the agreement. In other instances, parties fail to draft enforceable restrictive covenants, so as to ensure that a departing principal will not be able to compete with the business for a defined period after being bought out. Those are just a few of many traps that may exist, and those trap doors must be nailed shut.
In short, breaking up with your co-principal does not have to be difficult or expensive. The key is proper planning. The ugliest New Jersey business divorce cases tend to be the ones where one or more of the principals took matters into their own hands without the benefit of competent legal counsel.
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.
