Preventing Corporate Divorce: Why You Need a Business Prenup
Summary: Like domestic marriages, business partnerships can start off well, but over time and for a variety of reasons, the parties involved may choose to go their separate ways. This “corporate divorce” typically involves complex financial interests and more often than not, strong emotions.
Published in Businessing
Like domestic marriages, business partnerships can start off well, but over time and for a variety of reasons, the parties involved may choose to go their separate ways. This “corporate divorce” typically involves complex financial interests and more often than not, strong emotions.
Whether you’re going into business with a spouse, family members, friends or colleagues, it’s critical to treat the situation as you would any professional contract or agreement and get everything in writing upfront. Just because you get along with someone personally doesn’t mean you’ll have a successful working relationship.
There are ways to spot early warning signs and precautions to take to prevent your partnership from failing. If you’ve prepared yourself, and your partnership does begin to fall apart, you’re not caught in a lengthy and costly legal battle. Below are a few key methods to avoid a complicated corporate divorce.
Impact of Boilerplate Language in Corporate Governance Documents
If you’re drafting a shareholder agreement, bylaws, or operating agreement, you need to consider:
What kind of dispute resolution are you going to have in place?
For example, do you want to designate a third person to be a tiebreaker? If you end up going to court or arbitration, it will be much more costly. In some instances, it may be beneficial to go the more expensive route (arbitration or litigation) because then you’re not relying on one person (the third party) to be the ultimate decision-maker.
If you’re in a contentious, emotionally charged dispute, and one person has more money than the other, they can essentially get their way because they have the means to enforce their position. You could lose simply by not having the resources to fight for your position. Be aware of your partner’s financial resources from the outset because these resources can be used against you. They can control everything by virtue of having more money, even if they own the same percentage of the company.
Do you want to designate a trusted third person to break the tie?
There are obvious benefits and drawbacks of using a third party to break a tie. You have to be sure you can trust the third person since they will make the final decision, and you’re stuck with whatever they decide. Finding that person can be a challenge. Some choose a friend that’s also a lawyer; others choose a religious figure such as a pastor or rabbi – just be careful who you choose. Ideally, you have three members of the board of directors or managers so there’s never a tiebreaker issue.
Do you want to include a prevailing party attorneys’ fees clause?
Attorneys’ fee clauses can change the dynamic of a dispute because there’s a lot more at stake when the loser risks paying the winner’s attorneys’ fees and costs. Once again, if your partner has greater means to litigate a matter, you may lose simply because you don’t have the same amount of resources to put forth. You may end up paying more in the end. However, the existence of an attorneys’ fee provision may help you to convince a lawyer to wage the fight on your behalf.
Importance of Understanding Corporate Governance
There can be big problems down the road if you don’t stay current with your corporate governance. If you are a corporation and are not holding board meetings or regularly voting, make sure the corporation is designated a close corporation. If not, you could have issues because there are greater legal requirements on a yearly basis to keep your corporation up to date.
If you don’t follow those formalities, your partner could use that against you. If you don’t want to follow all of the corporate formalities, obtain the correct designation in order to avoid this. Perhaps most importantly, even if you have unanimous consent on everything, be sure to document everything. If you’re selling shares for example, be sure there is proper documentation of the deal terms and that corporate formalities are followed.
Be aware that if you are co-managers in an LLC, either manager can make decisions and the LLC is bound by those decisions. Right off the bat, each manager has full decision-making power and this can be very problematic.
Even if the operating agreement requires a unanimous decision– and without it the company can’t do anything– this doesn’t fully protect you against third parties seeking to enforce an agreement your co-manager made without your knowledge. The company is still on the hook for a co-manager’s bad decision or breach of fiduciary duty.
It’s also dangerous to get into an LLC and not have an operating agreement because states have default statutory schemes that apply to limited liability companies (LLCs). Those laws may not be helpful to you and won’t always protect you in certain situations. Depending on the ownership percentages, your partner could change the entire structure and ownership of the company without your input. Sometimes it requires only a majority vote and with that, your partner can take a lot of control and make decisions you may not agree with.
Using LegalZoom Versus an Attorney
Understandably, most would like to save money when it comes to setting up and operating their business. Therefore, it’s tempting to turn to options such as LegalZoom, which appear to offer legal documents that can put everything in place at minimal cost. If everything goes according to plan, you may be fine in the long run, but issues can pop up when there is a dispute.
For example, you have an idea for the next big app, but you don’t have the technical knowledge to get it off the ground, so you turn to your brother’s friend who is a tech guru—except he doesn’t perform the work. Without the appropriate corporate governance documents in order, you could lose ownership of the idea. Your brother’s friend could become a co-owner in any future company that utilizes the idea.
By trying to save a few thousand dollars on LegalZoom’s off-the-shelf documents that aren’t tailored to your specific needs, your brilliant idea is now worth a lot less, or worse, nothing. Keep in mind that it doesn’t take an unscrupulous partner to result in a negative outcome. If your partner dies, you could end up being in a partnership with their spouse or heir, which could completely alter the dynamic of the company.
To save money and ensure you’re protected, ask your attorney for a template, and handle the first draft yourself. Then, have your attorney review it to make sure you’ve dotted your i’s and crossed your t’s. It’s important to remember that the wrong type of agreements won’t hold up in court (e.g., handshakes and email exchanges); you need to memorialize your agreements the right way.
Red Flags When Negotiating and Structuring Deals
When you’re in negotiations, it’s fine for the other party to say they’re not comfortable with something, but pay attention to what they’re not comfortable with. Is it bringing in a third party? This could signal the other person is trying to get control or be in a position to. Are they comfortable with a prevailing party attorneys’ fees clause? This could create a problem because it may show they can afford to litigate while you can’t. Your partner’s position on key boilerplate terms will tell you if they are being reasonable or trying to get the better of you by using the law as a weapon.
Consider negotiations of governance terms as part of the interview process. If something doesn’t feel right and nothing has been signed, you can still pull out. Don’t be afraid to walk away, even if you’ve invested money and resources, because it could be much worse if this happens further down the road. Consider conducting a background check even if you’ve known your potential partners for years. Most importantly, before you put money toward anything in the business, invest in getting agreements set up the right way.
Once you’ve decided to move forward, even if you’re passively involved, keep tabs on accounts until the company is making money and then you can consider loosening the reins. Get monthly statements. Don’t just assume your partner will perform their agreed portion of the work correctly or at all. The last thing you want to do is figure out how to get control back.
If you do go the route of hiring an attorney to handle your business matters, make sure they express real interest in your company and tailor everything to you. They should ask a lot of questions about the business and care about your success. You should feel like you can pick up the phone and ask them quick questions with a prompt response.
A final and somewhat obvious, but important, tip: If there is anything in the other person’s past that is questionable, even if they simply participated in it, they can and likely will do the same to you. Ask questions and trust your intuition.
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