By Rajnish Puri
Generally, it is friends or family members who jointly create a new business and in doing so, become business partners. So, why is it that, only in a matter of time, the once-friendly relationships turn sour and, as business partners, the same friends and family have disputes and, in many cases, litigate against each other? Primarily, money matters . . . I believe. How can such disputes be prevented? The famous motion picture in the late 1970s – All the President’s Men – offers a clue. Remember Deep Throat’s advice to Bob Woodward – “Follow the Money”? Agreed that those three words led Woodward to reach only the source of the problem in the famous thriller about the Watergate scandal. However, the advice, if followed when creating agreements among business owners, can bring clarity to expectations in the relationships, avoid fallouts and, most importantly, retain the original friendships – the primary idea being about keeping an eye on the money from the time of investing in, to the moment of exiting, the business. In that context, this article offers key ideas to consider for agreements among shareholders of corporations, members of LLCs, and partners in partnerships. For convenience, in the discussion below, the term “owner(s)” includes shareholders, members and partners and, similarly, “company(ies)” means privately-owned corporations, LLCs and partnerships.
Capital Contributions. Businesses need capital, certainly at the launch and frequently at later stages. An agreement among the owners should specify the initial capital contributions they are expected to make to the company in exchange for their ownership interest. That’s the easy part. But, what happens when the company needs more money? The owners must identify the decision making process to make calls for additional capital and establish the timing and other limitations. It is just as important to agree on the consequences when one or more owner fails to satisfy the request for new capital. These may include automatic dilution of ownership percentages in the company or, if other owners step in to make up for the shortfall, whether to treat the shortfall as a temporary loan. Just like the inflow of money, its outflow, too, requires attention. In addressing the distribution provisions, owners must describe the criteria for making the distributions and other considerations, like mandatory tax-related payments and repayment of the invested capital before the sharing of profits.
Management and Control. Although the concepts of managing and controlling the business do not directly involve money issues, they indirectly impact such issues. Owners should clearly define the role each would play in the operations of the company and set the voting thresholds required for approving major decisions. Often, the responsibility to operate the business rests with a few. A sensitive item is whether or not the operating owners should be entitled to any compensation, which is an expense that reduces the profits. Without clarity on the issue there’s the risk of some owners feeling they are receiving less benefits than the others. Similarly, when dealing with the important subjects – typically involving significant money matters such as borrowing, adding new owners, disposition of major assets, real property agreements, and material business agreements – the stakes are high and so is the need for an understanding among the owners as to who among them is/are best suited to authorize decisions on such crucial matters. Arguably, everyone would like to have a say, but the unanimous voting requirement would give everyone a veto, which might lead to more problems than solutions.
Transferring Ownership. Unlike publicly-held companies, investments by owners of private businesses are generally not liquid. There may arise situations in the future when one or more owners wish to cash out from the business for different reasons. Once again, money plays a role. Equally compelling is the need to ensure that the entire ownership of the company remains among friendly parties. The two objectives, sometimes inherently conflicting, are addressed through provisions that require the selling owners to offer their equity interests first to the company or the other owners before selling them to third parties – referred to as the right of first refusal. A similar situation exists when a significant number of owners wish to sell their interests but others do not. The majority achieves its goal by providing in the agreement a right to compel the minority to join the sale – referred to as the drag along right. Both scenarios require the owners to deal with the selling price. Incidentally, under both situations, third parties play a role in influencing the sale price.
Exits – Forced and Unforced. Finally there are circumstances – some forced and others unforced – that compel an owner’s exit from the company. Death, disability, retirement, termination of employment (where owners also are employees), marital dissolution and personal bankruptcy are some such situations. To address these exigencies, owners should ask themselves the following three questions: first, who has the right or obligation to acquire the interests of the affected owner; second, how is the affected owner’s interest valued; and third, what are the terms of payment? Absent answers to these questions in the agreements, owners may find themselves in undesired and costly disputes among each other.
Hope you found the above discussion helpful. In my upcoming posts, I plan to share with the readers practical knowledge and trends on a variety of corporate finance topics applicable to early stage and established businesses. Stay tuned for another conversation on ClarkTalk!! If you have questions, feel free to contact the author by email at firstname.lastname@example.org, or telephonically at 213-629-5700.