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Avoiding an Ugly Business Divorce

Lerch Early Legal Update

When I was growing up, there was a popular TV commercial for a national automotive repair chain that encouraged potential customers to address small problems up front, rather than waiting until larger, more expensive issues emerged. To emphasize the point that ongoing maintenance was far cheaper than replacing an entire engine or transmission, the mechanic in the commercial looked directly into the camera and said with a menacing laugh, “You can pay me now…  or you can pay me later…”

As a litigator who handles lawsuits between current and former business partners (an area of litigation known as “business divorce”), I often think of that admonition when I see business partners who each own 50 percent of a business stuck in expensive, time-consuming litigation with each other that could have been avoided if they had taken simple precautions. These precautions include having a lawyer draft  an  operating  or  shareholders’  agreement  spelling  out  their  rights  and obligations and planning for various contingencies. While skipping the preparation of an agreement is an understandable means of saving money, this critical omission leaves these owners vulnerable to exhaustive litigation should an issue arise that is not addressed by written agreement. Below is a representative scenario, based on actual events, of a lawsuit between 50-50 partners that could have been avoided with some preventive medicine—all for a fraction of what a lawsuit costs.

When a Handshake Isn't Enough

Imagine a chain of local hardware stores owned by two old friends, Sal and Ken, each owning 50 percent of the company’s stock. Close friends all their lives, Sal and Ken trusted each other implicitly, so much so that they committed much of their life savings to their venture without any kind of written shareholders’ agreement between them. For years, the absence of such an agreement presented no problem whatsoever; profits were steady and Sal and Ken agreed on all business decisions— big and small—with a handshake. Unfortunately, in addition to lacking a shareholders’ agreement with Sal, Ken also didn’t have a will or estate plan.

When Ken died unexpectedly, Ken’s wife, Susan, inherited his shares of stock in the company and thus became a 50 percent owner. Sal and Susan now owned the company as 50-50 partners, but unlike Sal’s cordial, cooperative relationship with Ken, Sal and Susan could not agree on anything. The once- thriving business declined as disputes emerged over how the company was spending its money and the direction it was heading. Expensive litigation ensued, as both Sal and Susan filed suit against each other attempting to wrest control of the company, and to recover money that each felt entitled to.

How Are Decisions Made If There Is No Consensus?

This real-world story provides insight into three key issues that 50-50 partners need to address in an operating or shareholders’ agreement. First and foremost, business owners holding equal membership interests must decide at the outset how decisions are to be made if consensus can’t be reached. There are several ways 50-50 owners can  preempt  this  issue  in  a  written agreement, including requiring mediation of any disputes, inserting a buy-out provision, or requiring submission of decisions to a third-party for a binding resolution. Without planning for this contingency ahead of time however, impasses are all but guaranteed.

Who Is Responsible For What?

Second, and related, a written agreement between 50-50 partners must delineate which partner will undertake certain responsibilities,  so  that  it is  understood  which  person  is responsible, for example, for recruiting, hiring and firing employees, for purchasing and selling, paying taxes, etc. An additional benefit of setting forth this understanding in advance is that if the partners agree on who is responsible for various matters, it provides additional protection from management impasses developing later on.

What Is the Exit Strategy?

Third, it is critical to address in advance what happens if one of the partners dies or wishes to exit the business and transfer his or her interest to someone else, including someone whom the remaining partner does not know or may not want to work with. Fortunately, this issue can be addressed very easily with a common   clause in an agreement, providing the surviving member with an option to buy out the deceased member’s interest, or, at a minimum, providing the remaining partner with some authority on who will replace the departing owner.

These are just a few examples of the myriad pitfalls that 50-50 partners can face when proceeding without a governing agreement and assuming that irreconcilable problems will not emerge. While there are some initial legal fees incurred by new business owners to establish an operating or shareholders’ agreement, those costs are only a fraction of the cost of a future lawsuit if disputes later arise.

Bill Goldberg is a litigator who advocates for business owners facing commercial disputes, including partnership dissolutions. For more information about how to secure the best terms in a business break up, contact Bill at (301) 907-2813 or wagoldberg@lerchearly.com.

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