By: Stacy Schwartz
Over the last few years, the firm’s business litigation department saw a substantial increase in disputes between partners, shareholders and members of small businesses. No matter the type of business involved, the cause of the disagreement or how it began, the disputes have generally shared a common factor: a lack of planning during the start-up phase of the business. When owners do not take the time to plan for events, even when the business is small or the possibility is remote, they may suddenly find themselves in an adversarial situation incurring a great deal of time and money.
Oftentimes, starting a new venture involves trying to minimize start-up costs and conserve resources for getting the business off the ground. Usually too little time and money is allocated for consultation with legal counsel and having appropriate legal documents prepared. In many instances, the excitement of starting a new business and the preparations to begin operations take precedence over proper legal planning. Many new business owners do not take the time to discuss foreseeable future events that may affect the business, such as the death of an owner, a divorce, a management dispute or the departure of an owner from the business. Unfortunately, a decision to avoid or delay tackling such important issues at the beginning of a business relationship can lead to lengthy and costly litigation. While it may cost several thousand dollars to have a good set of governing documents created, even minor corporate litigation will likely cost in the tens of thousands of dollars. Once a management dispute escalates to litigation, it is too late to change what could have been done in the past. Moreover, without written documentation to govern or guide the resolution or conclusion of an ownership dispute, the parties become subject to state laws and procedures. With no framework in place, the fate of a business and its owners will be in the hands of a judge or a jury to decide how the disagreement should resolved.
There are several types of business disputes that are routinely litigated when circumstances change, and could perhaps be avoided if the owners take the time to address them before they occur.
1. Spend the Time and Money To Have Corporate Documents and Ownership Agreements Prepared
Whether you are creating a closely held corporation, limited liability company or a partnership, the key to avoiding disputes and litigation is having documents prepared that memorialize the owners’ agreements upon the occurrence of specific events. If, at the creation stage of a new business, the owners thought they would end up in a business dispute with each other, then they would not likely plan to be into business together at all. However, the fact is, business relationships, much like personal relationships, do not always remain positive and do not last forever. Parties may have the best intentions and share the same objectives when starting out together, however, over time, owners may develop differing views on the goals of business and business management. The owners should discuss their expectations of the business, how management decisions are to be made, resolving deadlocks and their future plans in the business. Although a lawyer can act for the new entity and initiate its formation, it is often helpful and sometimes necessary for individual owners to consult with their own legal counsel to receive advice on legal matters that may be specific to the business or their individual situation.
In the event of a dispute among owners, the first documentation your attorney will ask for will be the company’s governing documents (i.e., shareholder’s agreement and bylaws in the case of a corporation, operating agreement and articles of incorporation in the case of an LLC). These documents will set the tone for litigation. Therefore, it is extremely important that the owners take the time to ensure that they understand and agree to the terms contained in the entity’s governing documents. The best time to agree on the terms contained in the governing documents may be in the very beginning stages of the new business. Generally, at that time, the parties are on equal footing and open to negotiation of terms. However, it is never too late to create, amend or add to governing documents. If the creation of documents was somehow overlooked in the beginning, the owners should take the time now to sit down and have them completed. Having written documentation benefits everyone because it helps eliminate the risk of the unknown and can guide the parties through the unexpected.
2. Determine How the Company will be Managed and How It Can Overcome Management Disputes
What happens when owners cannot agree on a key management decision? An impasse between owners and management may not only harm the business but could lead to dissolution. Companies must have an agreed upon management structure. In the case of a corporation, the owners must decide how many board members will comprise the Board of Directors. Under Florida law, the Board of Directors is charged with the ultimate responsibility for operating the corporation. If the shareholders choose an even number of Board Members, there must be a mechanism to break a tie vote. Without clear governing documents that define management operations, a successful business venture can be ruined as a result of internal strife. This is particularly the case in entities where the ownership is divided among equal ownership factions. Small businesses are especially susceptible to ownership and management disputes. Such disputes may lead to ultimate judicial dissolution of the business. Thus, it is imperative that the owners decide ahead of time how they will deal with a deadlock. There are several mechanisms that can be built into the governing documents, such as appointing a neutral third party to break a tie vote, providing the owners with tie breaking authority on different issues, or even an agreed dissolution. Although an agreed dissolution might seem like a drastic remedy, the fact is, if equal owners reach an impasse on a key management issue, it may be desirable to implement an orderly break up and avoid a forced liquidation.
3. Determine How Owners Can Exit the Company and How New Owners Can Enter
There are numerous reasons why an owner may exit a small business. In some professional organizations, retirement or loss of licensure will require an owner to withdraw. If a dispute develops between owners, and one is willing to leave, the exiting owner will want a pay-out for the value of his ownership interest. The value of an exiting owner’s interest is often a heavily litigated matter. One way to avoid litigation over the manner and methodology of a buy-out is to include a Buy/Sell provision in the contract between the owners. There are numerous ways to structure a Buy/Sell provision. The structure and methodology of the Buy/Sell will likely be dependent on the nature of the business, owner’s contributions and tax considerations. A Buy/Sell typically includes a previously agreed upon formula or method to value an owner’s interest and thus eliminate the potential for dispute when such a provision is triggered.
Changes in business can also lead to changes in ownership. Growing companies may consider new owners as a means to raise capital or replace exiting owners. During the initial stages of a small business, owners should decide how they will allow new owners into the business and on what terms and conditions. If an owner decides he wants to exit, how will the owner’s interest be acquired? Many small business agreements contain a right of first refusal. A right of first refusal requires an exiting owner to offer to sell his interest to the business or the other existing owners prior to, or in conjunction with, soliciting third party offers. The right of first refusal allows the current owners to maintain the company close to the status quo without the introduction of a stranger into the business who might not share current ownership’s views.
4. Plan for Future Events
In a small entity, particularly a family run entity, the divorce of an owner or the inclusion of new family members or the children of current owners can lead to animosity. A family business may thrive in one generation and struggle in the next, leading to an inevitable break-up. An orderly transition can occur much easier if the governing documents contain a separation plan. If any of the owners are married, the governing documents should plan for possible divorce and articulate how the company will continue to operate and manage itself. A divorce often involves valuing the owner’s interest in a business for division of martial assets. This can cause havoc and subject the business to litigation and litigation expenses. There are probably few scenarios where owners who divorce are able to continue to work together. Thus, terms can be included in the governing documents to allow for transfer of an interest in a less intrusive manner.
Death or incapacitation is another unavoidable event that should be planned for ahead of time by the ownership. Upon the passing of an owner, the other owner(s) may be forced to continue business with the deceased owner’s heirs, such as a spouse or children who may have different or competing views about the business. Provisions can be included in the governing documents to prevent a change in ownership which might adversely impact the remaining owners. This may include an automatic buy-out procedure so that the remaining owners do not become forced to operate business with individuals with whom they never intended to become engaged with in a business venture.
Time and resources can be saved when parties take the time to set-up a solid foundation for a new business. By thinking ahead and about possible future events that may affect a business, business owners can plan to be prepared for changes within the business. Preparation can be a key factor in diminishing possible legal disputes within a business.
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