Businesses can be structured in many different ways, each with its benefits and disadvantages in terms of taxation, asset protection, and day-to-day operations. Some of these structures allow for the collective ownership of the business by two or more owners. In these situations, each owner (sometimes referred to as a partner, member, or shareholder) is partially invested in the company.
Collective ownership is ideal for many businesses, as it reduces not only the tax-burden and day-to-day responsibility, but also the liability risk for individual owners. However, what happens when partners wish to sever this business relationship? This is sometimes referred to as a “business divorce” and much like a matrimonial divorce, can get complicated, legally drawn-out, and rather messy.
An experienced legal team can certainly ease this transition. However, even the most knowledgeable professionals will have difficulty if the company’s formation documents are ambiguous or incomplete.
The Importance of Strong Formation Documents
Upon company-formation, the importance of drafting comprehensive and concise formation documents cannot be overstated. These contracts (which include buy-sell agreements, founders’ agreements, and operating agreements) are paramount in resolving complicated or emotionally-loaded disputes. Likewise, they should determine the procedure in the case of a partner’s dissociation from the company. Unfortunately for many businesses, their documentation fails to establish these fundamental rules.
For instance, while formation documents should contain well-thought-out dispute resolution provisions, many only have standard arbitration provisions to handle all disputes. Resolution provisions should instead be tailored to the company and the dispute, and clearly mandate how various types of disagreements will be handled. When well-executed, these provisions can either ease the divorce or avoid the process all-together.
The alternative to resolution provisions many-times involves prolonged disputes and litigation, which is not only time-consuming and expensive, but reduces the control that the partners have over the outcome of the dispute. In general, litigation should be avoided at all costs. Involving a 3rd party (such as an arbitrator or court) essentially makes them a “new” business partner and reduces the control of the true owners.
Other Considerations in a Business Divorce
Strongly-written formation agreements can go a long way in resolving or addressing difficult business disputes. However, when the business divorce is inevitable, there are a number of other considerations that should be accounted for:
A Founder Separation Agreement
A founder separation agreement is essentially a contract that outlines the terms of which a partner (or partners) will depart from their ownership role. It should include clear language regarding the company’s ownership, a vesting schedule, intellectual property and trade secret provisions, and procedures for returning company property. Akin to an operating agreement, the separation agreement should be comprehensive, clear, and produce a predictable outcome. The ultimate goal is to make as “clean of a cut” as possible given the difficult situation. A strong separation agreement will preserve the business and protect the remaining partners.
Once a partner dissociates from the company, they still pose a threat to business operations. The founder separation agreement should include language that prohibits partners from leaving and starting a competing business or joining a direct competitor. Unless a non-competition clause is specified, it is perfectly legal for a past owner to provide their skills, expertise, and experience to a direct competitor.
Different kinds of Tax Considerations
One of the great benefits of partnership-driven business structures (such as corporations or LLCs) is the differential tax treatment. However, this may certainly change upon the leaving/joining of owners. Depending on the situation, a partner’s departure can have significant consequences on the capital gains of the other owners. Exactly how the tax situations will change is difficult to determine, and usually requires the consultation of a professional.
In some situations, one partner may want to “buy-out” the other(s). A strong buy-sell agreement would be ideal in this situation, however not all businesses have them. Either way, a company valuation must be performed. There are a few different ways to do this: fixed price valuations, adjusted book values, and fair market valuations are among the most common. Valuation is consistently a point of contention—in-fact, even deciding on a valuation method is typically debated between buyers and sellers.
Although these considerations are certainly worth attention, many business divorces are simply unpredictable. Well-written formation documents tend to ease the division process. However, much like a matrimonial divorce, divvying-up assets and ownership rights will always be complicated, emotionally-charged, and time-consuming.
An experienced business lawyer should be consulted before making any irreversible decisions. In the majority of business divorce situations, litigation will only complicate the process and should be considered a last resort. A well-crafted separation agreement—with non-competition provisions included—can take much of the pain out of a business divorce, while preserving the integrity of the business and protecting the remaining owners. Likewise, partners will have to decide on a valuation method that is fair to all, and each member should consider how their tax situations might change before making any drastic decisions.