Small business break ups

Based on the comments I get from readers, one of the hottest topics on my blog are posts dealing with small business break-ups--be they partnerships, corporations or LLCs. As I've written before, within those disputes, one of the biggest struggles involves the inequality among partners or business co-owners, i.e., what happens when there are equal owners making unequal contributions.

What often happens in such cases is that the business breaks up. In worse cases, the disputes end in massive lawsuits, ugly recriminations, and financial ruin.

Where I've found this potential to be at its greatest is with the formation of those businesses where the co-owners are bringing different things to the table. For example, maybe one person is bringing money, another one is going to do the work, and perhaps a third is contributing an invention or patent that's going to make a million dollars. Each person is bringing something to the business, such that the whole is greater than the sum of its parts. Ironically, however, over time, these very differences can breed resentment among the partners and eventually cause business break-ups.

For example, at the beginning of the above hypothetical venture, the "worker" is getting the best of the deal: the money man risks losing capital, as, to a certain extent, does the inventor. The worker just risks losing his time, but nothing more.

Five successful years later, however, the dynamics may have changed. The capitalist and inventor are enjoying a nice return on their investment. The worker, however, is resentful: the business would stop without him. Whereas the capitalist and contributor have received back their investment (and then some), the worker continues to have to invest his time, effort and labor into the business.

I have also watched similar situations play out in a different manner. I've watched an "idea man", perhaps willing to do the work, who gathers up willing monetary investors. He's promised the investors great potential, and wonderful returns some time in the future. When things get successful, it turns out that he's issued himself so much stock, he effectively controls the company. The investors get little in the way of dividends, because by the time the idea man has paid himself a nice salary and benefits, there's little left. Theoretically, their stock is creating equity, but because their company isn't publicly listed (or, in an alternate scenario I have seen, they learn the shareholders' agreement has a provision requiring them to offer their stock back to the company at preferential rates prior to selling to a public buyer), the investors now have little hope of ever seeing a meaningful return. In other words, the passive investors' investments are held hostage.

Although attorneys do a good job of foreseeing the "worst case" scenario--i.e., what happens when things go awry--we also need to prepare for best case scenarios--i.e., what happens when things are going very well, and the equities have changed.

Here are just a few ideas to allow the continuation of a small business, even when the business contains different types of investors:

1. Provide benchmark dates at which the investments are vested, and any future contributions are paid for at arm's-length. This is a hard idea to pin down, except by way of example. Go back to my initial example of three different investors, each with a very different type of investment. Each investor, theoretically, could be benefited more than the rest, or less than the rest, depending upon how the company was structured. But they could all be treated fairly, if they come up with success benchmarks that allow them to treat their investment as having been fully paid in.

In the example of the worker, the company's organizational agreement could state, for example, that after the company reaches $X sales per year, the worker will be paid a salary--or perhaps, can hire staff and no longer have to contribute his own services. He is no longer captive: he's either now an investor and a paid-employee (in the first example), or else a passive investor like the rest (in the latter example).

For the inventor, perhaps the same agreement should state that after some benchmark (perhaps Y years), the inventor's patent will simply be licensed to the company, on a yearly basis, for a certain sum of money.

In other words, to avoid disparities later in the company's existence, you create a system so that the investors' later contributions of time, effort, or whatever, are compensated on an arm's-length basis.

2. Create, at the outset, scheduled pay-outs or buy-backs. In the other example, of the passive monetary investors, they contribute all the risk, but the idea man, as the business becomes successful, effectively shuts them out and sews up their contribution. Investors should recognize this as a risk, and ask for organizational documents that create some type of guaranteed payout--be it through a guaranteed buy-back, guaranteed dividends, or the like.

3. Create, in the organizational documents, forced buy-out or buy-back provisions. At the very least, you could place in the organizational documents provisions by which you can force a buy-out or buy-back, at an agreed upon price (or agreed upon pricing mechanism) during a certain time period or after a certain triggering event.

Interestingly, of the small business disputes I've seen, at least as many of them stem from business success as do from business failure. When setting up or starting a small business with numerous investors, don't just think about the worst-case scenario: ask yourself, what problems arise if the best case scenario occurs?