Forming a Business – Deadlocks, Disputes, and Transfer Restrictions

Forming a business with your business partner is an exciting time and one during which most people avoid thinking about what may go wrong.  As exciting as it is, the parties should still take some time to think through the issues that might arise.  Here are a few things the parties should consider:

1) Approval Requirements and Deadlocks

For partnerships, corporations, and limited liability companies, a number of issues can arise depending on the number of owners.  If there are two equal owners, or multiple owners with ownership interests that can easily add up to a 50/50 dispute, deadlocks can occur.  If there are owners with minority interests, the majority interest holder(s) can likewise overrule the minority if the voting requires simple majority.  Accordingly, the parties should consider (1) certain actions which require approval of a specified percentage of owners (or percentage interests) and (2) deadlock provisions.

Approval Requirements

Approval requirements are centered on the business deal of the parties.  If one party holds all the cards, they are most likely going to make all of the decisions.  However, assuming that there is room for negotiation, the parties should consider acts that require approval of all of the owners or at least a super-majority (usually defined as 66.67% or 75%).  A few areas in which the parties should consider unanimous or super-majority approval include:

1. Any amendment to the operating documents;

2. Any requirement that any owner make additional financial contributions;

3. Incurring of any contractual obligation or the making of any capital expenditure with a total cost in excess of a specified amount;

4. Incurring of any debt, or debt refinance in excess of a specified amount;

5. The purchase, exchange, or sale of major assets;

6. Dissolution of the business;

7. Approval of cash distributions;

8. Settlement of any lawsuits or claims; and

9. Filing for bankruptcy.

Deadlocks

Deadlocks naturally arise in settings where the parties have equal rights. These deadlocks can be resolved through various means. It may sound silly, but for small disputes (think very minor), I recommend a coin flip. For others, you can give the authority to cast the deciding vote to a third-party tiebreaker. Similarly, you can engage in regular arbitration or “baseball arbitration,” meaning that the parties each submit their proposal and the arbitrator selects one without adjustment. Further, you can mandate the dispute be resolved through the formal dispute resolution method described below. The list goes on and on and the parties are even free to come up with their own method (I’d love to draft a rock-paper-scissors provision!). Regardless, the point is that the parties can sort through these issues now.

 2) Dispute Resolution

Even the best business partners find themselves in business disputes.  Although it is impossible to predict when or if such a dispute will ever arise, the parties can agree how they will handle one should the situation arise.

If left unspecified, the default is litigation unless the parties agree otherwise.  What that means in practice is the filing of a complaint, service of process, an answer by the defendant (and any cross-complaints), discovery, experts, motions, settlement conferences, mediation efforts, and, if all else fails, trial.  Beyond the dispute, what that also means is $$$$$$$, psychological damage, and wasted time.

As an anecdotal tale, early in my career I was involved in a dispute between business partners/husband and wife.  Skipping the juicy details, I was shocked during a meeting when the senior attorney on the case told our client that he could expect to spend at least $500,000 (!!) to get the matter to trial.  Even the smallest matters I worked on in my prior life as a litigator, meaning the ones that were just letter campaigns pre-filing of a lawsuit, usually came with $10,000 attorney fee price tags.  The fact is that disputes are costly.

So, how should you handle it?  There is no perfect method because we are talking about something that may arise in the future and you never know what side you may be on.  That said, my main recommendation is to include a “Dispute Resolution” clause which requires that the parties meet and confer first, mediate second, and litigate or arbitrate third.[1]  The hope is that by forcing the parties to meet and confer first and then mediate, the business parties may be able to reach an amicable solution early on when costs are low and disruption to the business is still minimal.  As an added bonus, mediating the matter early on gives the parties the benefit of a third-party opinion regarding the merits of their position.  Without such a provision, mediation does not normally occur until the parties are gearing up for trial.  At that point most of the expenses have already been incurred by the parties (note the placement of “mediation efforts” above).

If mediation fails, litigation or arbitration comes next.  With that comes significant fees.  To counter this I recommend a broad attorneys’ fees provision for the prevailing party (which means the loser pays the winner’s attorneys’ fees and costs).  This alone can provide a disincentive for frivolous litigation.

That said, there is no perfect method but at least with a contractual agreement among the parties you have certainty about how the dispute will progress – control the things you can.

 3) Restrictions on Transfer; Buy-Sell Provisions 

The next big area that owners can agree upon is what we call the Restrictions on Transfer and Buy-Sell provisions.  These provisions govern the rights of the business and the other owners to essentially control the parties with whom they are in business and also force other owners to sell on the occurrence of specific events.  Think of it this way.  You start a business with an individual named Clark Griswold.  Years later Clark decides he needs a vacation and wants to sell his interests to his cousin who we will call Eddie.  The Restrictions on Transfer and Buy-Sell provisions protect you from having to run your business with Eddie.

Restrictions on Transfer clauses state that an owner may not sell his or her interest without the other owners’ consent unless to a pre-approved category of buyer.  For instance, your goals may be to transfer the business to your kids one day or, for estate planning purposes, it may become beneficial to have your interests held in trust.

Buy-Sell provisions state that on the occurrence of certain specified events the business and/or the other owners have the right to buy the ownership interests of another owner, at a specified price or pursuant to a pre-determined formula, and on specified payment terms.  Typical events that trigger the Buy-Sell provisions include:

1. Transfers and sales of ownership interests (e.g., Clark’s attempted sale to Cousin Eddie);

2. Retirement/Withdrawal;

3. Death;

4. Disability;

5. Dissolution of Marriage (think about doing business with your partner’s angry ex-spouse); and

6. Bankruptcy.

As mentioned above, these provisions should include how the purchase price is determined should a Buy-Sell event occur and what payment terms will be utilized.  Should there be a discount for an owner that skips town and leaves the other owners struggling to maintain the business?  Should there be a discount for minority interests?  Should the price be paid in cash, under a promissory note, or through some combination?

Like most matters in an agreement, the specifics are subject to discussion and the parties may ultimately decide that they do not want any Restrictions on Transfer or Buy-Sell provisions.

Closing Thoughts

Forming a business is an exciting time and one that is almost always hectic.  Let’s be honest though – the contractual side of it may not be your first priority.  As such, in my opinion, the goal of any attorney should be to provide their clients with a complete understanding of the issues that may arise, possible solutions, and ultimately, an agreement that embodies the business deal of the parties.

[1] California law mandates that mediation efforts are confidential absent an agreement to the contrary.