Volume 8 Issue 2
Deadlocks in Small Businesses:
Dont Assume Harmony
© by Tax & Business Professionals
Many business relationships, like other relationships, begin
with the rosy assumption that there will never be a problem that cannot be resolved by reasonable
people. Experience shows, however, that there are frequent cases of "deadlock"
resulting in interminable friction or, even worse, litigation.
Some wags have described small business as a "marriage
without sex." Problems inevitably will arise, and deadlock can result when the
parties reach a point that they can no longer "kiss and make up."
Deadlock can arise when, because of persistent disagreements,
no one owner or group of owners can effectively exercise control and make decisions, or a
minority may have a virtual "veto" power over anything the business wants to do.
Often, preceding deadlocks there is a common pattern involving
a new entity with little or no documentation between the owners. Often the business is
initially successful, otherwise the business would never get beyond the formative stage.
Unfortunately, many small businesses in the formative stages
dont care about business formalities and do not prepare formal agreements, corporate
minutes, bylaws, and the like. (While we may use corporate terminology in this article,
the same principles apply to partnerships, LLCs, etc.).
Far too often, attorneys and advisors assisting new businesses
fail to advise commercial neophytes of the need to consider and document what will happen
if, for example, one of two shareholders: (a) refuses to guarantee new corporate debt, (b)
refuses to work full-time, or (c) dies or becomes disabled? The list of possible trouble
spots can go on and on.
Perhaps the more common source of deadlock is simply the
certainty that, over time, there will be disagreements. As in marriage, people and
situations change and mature over time. Most businesses disagreements can be
resolved, but some cant, and when the differences cannot be reconciled, deadlock may
ensue, particularly with two equal (50-50) owners.
After the deadlock develops, the owners discover,
to their horror, that they have ignored all documentation that could help resolve the
deadlock. There are often no bylaws, minutes, or other agreements which could shed light
on how decisions can be made and problems resolved. Surprisingly often, there are
disagreements about who owns how much stock. (Tip, if an "S" election has been
filed, IRS Form 2553, an answer to stock ownership questions may be found in that form)
Plan for Tomorrow
The overriding message of this newsletter is to prepare
documents, now, controlling ownership and how meetings and specific problems will be
handled. Potential problems and foreseeable events (e.g., death and disability) need to
have a mechanism for resolution. How many times have you heard the distressed middle-aged
person state that a pre-nuptial agreement is a good idea, only after he/she has begun the
woeful unraveling of a second or third failed marriage?
Most small businesses need some or all of the following
planning devices, regardless of whether its a corporation, partnership, or LLC, although
the precise terminology may change:
(1) Stock certificates or other clear records of ownership to
establish ownership and control.
(2) Bylaws (or a partnership agreement or LLC operating
agreement), which are similar to a constitution or charter and are used to define and
describe basic operating functions and procedures, such as how many are needed for a valid
meeting and what percentage of agreement is needed to approve a matter. Without these
basic governing devices, when there is disagreement the parties usually cannot agree as to
how, or in what manner, they will resolve it.
(3) Buy-Sell agreements (sometimes called stock redemption
agreements), which can be used to address the consequences of events like death,
disability, retirement, or the termination of employment of an owner. Often, such
agreements will also include "covenants not to compete" or nondisclosure
provisions designed to prevent the departing business associate from taking customers or
business knowledge and using it in an impermissible manner.
Whether you have all, or some, of the above mechanisms will
depend on the owners and their willingness to think about "tomorrow," before an
important entity-splitting decision is thrust upon them.
Assuming all else fails and the owners remain at loggerheads,
there is the judicial system. Most states have some form of judicial remedy to remove the
impasse. Often these remedies, like "judicial dissolution," are nothing more
than orderly death to the business. Litigation growing out of deadlock, like divorce
proceedings, is usually not so much a solution to the problems but rather a way to
sidestep them and terminate the relationship. And, like divorces, these legal options
often turn bitter, as the business disagreements fester into personal animosities.
Think about tomorrow! Dont allow your
business relationship, or those of your clients, to go unattended.
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