Planning for a Breakup?

The relationship between owners in a startup is often compared to a marriage.  Its an apt analogy in many respects.  The partners make a commitment to each other to be bound to the new company, for better or for worse, often agreeing to forego their own opportunities in the interest of the new company.  And when those relationships deteriorate, especially when there is a loss of trust, the breakup of the business relationship can be just as contentious and traumatic as the fiercest divorce proceedings.  Perhaps this is why many first-time founders treat planning for dissolutions and disputes with their cofounders as if they were suggesting a prenup to their significant other.  The hesitation  is understandable – the partners believe in the business and each other, why else would they have agreed to go into business together? 

But aside from deciding on equity distribution, planning for the future of the business (including potential disputes and breakups) is perhaps the most important conversation regarding the structure and operation of the new business to be had at the beginning of any new startup venture with multiple cofounders. 

In general, the considerations involved with the breakup of a business relationship is memorialized in an operating agreement (LLCs), shareholder agreement (corporations), or partnership agreement (partnerships).  There is no universally ‘right’ way to go about structuring the agreement, there just needs to be a mutually agreed procedure for handling disputes and the most common events relating to the cofounders that affect the business. The best time to do this is, of course, when everyone is still getting along at the beginning.  Failing to address these considerations becomes difficult and sometimes impossible when the parties are at odds.  For this reason, the majority of closely held business disputes that wind up in litigation start because there was no agreement between the founders.

So what needs to be in one of these agreements?  This will depend, to a great degree, on the type of business, the members and what they bring to the business, and each equity holder’s views for the future of the business.  Regardless of the many factors to be considered, there are four things that must be considered and planned for:

  1. Death.  What happens if a founder dies?  What will happen to his/her ownership interest?  Will they be allowed to transfer the equity to an heir?  If so, will the heir receive voting rights?  If there is no transfer of equity, will the deceased founder’s heirs be able to sell the equity or will the company be forced to buy it?
  2. Disability.  What happens in the event of the disability of a founder?  Will the founder continue to receive salary or dividends if he or she cannot contribute to the company?  How long will the founder be able to claim a disability? Who determines what constitutes a ‘disability’ and what procedure is in place to handle this?
  3. Retirement or Withdrawal.  How can a founder retire or decide to leave the business?  What type of procedure is required to start this process?  What happens to the founder’s ownership?  Will the company be required to purchase the ownership, and how will the price be determined?
  4. Disagreements or Termination.  What procedures are in place to settle business disagreements?  What circumstances are required for a cofounder to be fired?  Will the company force a terminated cofounder to sell his/her shares of the business?

There are many other considerations that come into play when discussing the complexities that surround the breakup of a business partnership.  But careful planning and open and honest discussions between founders, along with the assistance of an experienced business attorney to guide you through the process, will help eliminate many of the potential pitfalls down the road.