Key Issues in Business Formation
Part One of a Series
Payne & Fears’ Business Litigation Group helps businesses and their owners with wide-ranging disputes. In our practice, we’ve noticed that in disputes among business partners there are common issues that often surface. This is part one of a series of articles highlighting some of the most common problems. The articles will cover issues arising at several stages of the business relationship, from inception to ending the business. The topics in these articles are broadly applicable to all types of business entities from general partnerships, to LLCs, and corporations.
Americans are serial entrepreneurs, consistently starting new businesses. Data from the U.S. Census Bureau shows that more than 432,000 new businesses applied for tax IDs or Employer Identification Numbers in October 2022 alone. The survival of many of these businesses can be directly tied to their formation, especially whether the founders have adequately addressed compensation and the division of labor or power. These issues are key causes of business disputes among owners, partners, founders, and managers.
Avoiding these disputes starts with good preparation. First and foremost, sit down with your business partners and plan things out. In the formation agreement, define the expectations, responsibilities, and divisions of labor in the management of your new business, and also address the unexpected: death, disability, and differences of opinion regarding the operation and future of the new enterprise. Confront the tough issues at the outset—particularly those dealing with money and power. Because in our experience these two areas are the most frequent sources of division, we provide some suggestions on how to address them at business formation.
Money In and Money Out in Business Formation
Unsurprisingly, one of the most common disputes we see is an unhappy business partner complaining about compensation. These disagreements can turn ugly and transform into more global disputes over control or even breaches of fiduciary duties. Often, this can be avoided with a clear operating agreement. Detail the time, money, and assets that each owner is expected to contribute, now and in the future, and what each owner receives in terms of an ownership percentage, the right to future distributions and profits, and allocation of losses. The division of equity and the distribution percentages may not be permanent, but you should delineate if/when/how those numbers can, or will, change. Being able to point out the clear rules from a detailed and well-documented initial agreement often deters a lawsuit before its filed or helps resolve claims.
The Division, or Consolidation, of Power in Business Formation
Another common ground for disputes is management and control of the business. Frequently, businesses that do not plan ahead start with 50-50 ownership and control. These founders’ disputes end up in a stalemate. And failing to identify a resolution mechanism in the founding documents can often end with drastic results. Breaking a tie often requires one founder to buy the other out completely or dissolution of the business. The founding documents can instead identify a dispute resolution mechanism or a tie-breaking system to avoid these scenarios.
Similar problems arise from disputes regarding business management. Will one or more owners take part in the day-to-day operations? If so, determine the extent of and limits on those powers up front. Business owners with minority interests frequently come to us complaining that they cannot stop the manager from running the business in a way that they do not like. Sadly, many times these owners allowed the founding documents to give complete control to the managing owner, and while Payne & Fears attorneys creatively work with clients to overcome the issue, there may be few fruitful and economically viable avenues to pursue to make a change. This can be avoided with clear dispute resolution mechanisms and other protections.
The founding documents should reflect how business partners believe operations and management will be fairly handled. Ideally new businesses want to establish clear dispute resolution provisions that either give one or more owners the final say (for example, a majority in ownership interest rules), or require the owners to go before an ombudsman or mediator to resolve disputes. Many agreements will require that disagreements over certain issues be determined by a third party, either a formal arbitrator or a trusted third-party advisor. Finally, if one owner, or a small group of owners, will have more control than the rest, it may be necessary to create a mechanism to protect the minority, or even for the minority ownership to oust or unseat the controlling or managing owner(s) if there is mismanagement or a fiduciary duty breach.
Our attorneys frequently assist both majority and minority owners to litigate and resolve their differences, whichever is called for by the situation. Our experience is that for many successful businesses there is enough at stake that these types of situations end up before the court (unless you all agree that arbitration is appropriate). Your operating agreement should be drafted as though it will be exhibit “A” to prove who was supposed to do what, when, and how, and the consequences for not abiding by its terms.
There are many more issues you should discuss with your co-owners (and document the results) before you launch your new business. Some of these issues are difficult to raise—the enthusiasm and optimism needed to start a new business make it hard to bring up these issues. However, addressing the issues in advance and documenting them may pay great dividends in the future. We encourage you to speak with your trusted Payne & Fears attorney to discuss the specific issues relevant to any new business venture.