Individuals that choose to go into business with one another usually aren’t expecting for their relationship to go sideways in the future. Which makes it understandable—yet still unfortunate—that the question “What if my business partner attempts to push me out?” isn’t typically addressed until well after it is too late for the soon-to-be former colleagues to come to a mutual agreement as to the details of their looming separation. Often these feuding parties failed to execute an agreement during the initial phases of their enterprise that they could reference when their relationship went south for guidance on key issues such as decision-making, buy-outs, equity and ownership.
Yet even in cases where there is a valid agreement in place that covers these concerns, the break-up process for business partners—similar to romantic relationships—tend to be exceptionally contentious and can lead to disagreements over the interpretation and application of the standing agreement. The high stakes nature of these disputes can prompt expensive, drawn-out litigation. That is why it is essential to consult with an experienced small business attorney when drafting your formational agreements to ensure you have all your bases covered. This counsel can provide an invaluable, unbiased perspective in structuring the document to make it as effective as possible should the relationship become untenable down the road.
Partnership, Operating, Shareholder, Buy-Sell Agreements—What’s the Difference?
It is important to understand the distinction between partnership agreements, shareholders’ agreements and operating agreements. The short answer, is each of the first three documents apply to a different business structure. Partnership agreements are for partnerships (as one would expect). Shareholders’ agreements are found between shareholders of corporations. Operating agreements are the rules of the road for limited liability companies. A buy-sell agreement can cut across all business entity types, however, well constructed partnership, shareholders’ and operating agreements will contain the typical buy-sell provisions.
Partnership agreements are for partnerships, as one would expect by the name.
Written partnership agreements are not required in New York State to form a partnership. This is why you need to be careful when speaking to someone else about going into business together. You might find you’re in a partnership that you didn’t mean to create! But just as importantly, you want a written agreement not only to start but to be able to end properly. Just like you can easily form a partnership, you can easily end one – if it is oral – by declaring it finished. But what that declaration doesn’t cover is who gets what of the partnership once it’s dissolved. Therefore, the best way to protect your interests in a partnership is to have a written partnership agreement that explicitly discusses how, why and when a partner may exit, and what the consequences are of that exit.
Operating agreements are for limited liability companies.
New York State law does require written operating agreements for limited liability companies. Unfortunately, too many entrepreneurs use low cost, legal tech solutions to form their entities and don’t receive proper legal counsel about the importance of a properly drafted operating agreement.
The operating agreement establishes the rules applicable to all members of the limited liability company and ideally provides answers to some integral issues related to its sustainability and management, including:
- Who owns what of the business?
- What contributions does each member make to the business?
- How is profit distribution handled?
- What role does each member play in the day-to-day operations of the business?
- Will the members appoint a specific manager(s) to oversee the business instead of actively managing it themselves?
- Who has voting rights and how much does each count?
- What happens if a member wishes to leave the business or sell/transfer their ownership interest?
- How can new members join the business?
- Are the members allowed to force another member to leave the business and under what circumstances?
- How can the business be dissolved?
- What occurs upon dissolution of the business and how are the remaining assets allocated amongst the members?
- What happens in the event of a death or incapacitation of a members?
Shareholders’ agreements are for corporations, both C-corps and S-corps, and are between two or more shareholders in the company.
New York State does not require shareholders’ agreement. A corporation is required to have Bylaws, which address the government of the corporation. Bylaws cover the requirement of and timing of meetings for the shareholders and board of directors, how elections of the board are handled, the tenure of board members, the creation of committees, the issuance of stock, the responsibilities of officers, and other general governance matters. A shareholders’ agreement is an agreement between two or more shareholders’ to act together in a certain manner. Typically, founders enter into these agreements to ensure that the other founders vote their shares in a certain manner – i.e., each founder agrees to vote for the other founder to serve on the board, to agree to certain profit distributions, and how to buy or sell shares to avoid a third-party coming into ownership.
A buy-sell agreement can apply to any type of entity.
Essentially, a buy-sell agreement specifies how someone can buy into the company, and how someone will sell their ownership of a company. Often people address common situations such as disinterest in the business, disability, or death of one of the founders. For each scenario it lays out the process to put the ownership position up for sale, how to value it, how payments will be structured, and the like. The best drafted buy-sell agreements contemplate many scenarios and permit business owners to exit without destroying the business built.
But What If Your Business Partner Is Trying To Force You Out?
In the event your business partner is attempting to force you out, your fist move is to thoroughly review your entity’s written agreements. If some instances, these agreements will list specific scenarios in which an owner can, in fact, be forced out; for example, when an owner misuses business assets, engages in illegal or unethical activity, loses a professional license, or violates any other explicitly stated term of the agreement.
If there is a written agreement in place, your fellow owner(s) will only have the ability to force you out in accordance with the provisions of that agreement, provided you have abided by the terms of the agreement. This, of course, doesn’t mean that another owner cannot act in bad faith – we’ve seen it happen – but it does permit you to seek recovery and seek punitive damages if they do so.
Depending on your entity type, there may be certain legal remedies you can avail yourself of.
In a partnership, absent a written agreement, an owner can be “forced out” by the other partner simply by that other party declaring the partnership dissolved. If that happens, each partner would be entitled to one half of the partnership’s assets. There may be a need to engage a forensic accountant, valuation expert and an attorney at that point.
In a limited liability company, absent express inclusion of an expulsion provision in a signed operating agreement, New York state law does not permit other founders to remove a member from ownership. If you are facing a situation where a co-owner is attempting to freeze you out of limited liability company assets and decision-making, you should immediately contact an experienced attorney for assistance.
In a corporation, absent express inclusion of a buy-back provision in the Bylaws or a shareholders’ agreement, New York state law does not permit other founders to seize your shares of the company without compensation. If you are facing a situation where a co-owner is attempting to take your shares, you should immediately contact an experienced attorney for assistance.
What if No Agreement Exists?
When there is a dispute between business owners and no agreement is in place, the company is at risk of reaching a deadlock situation. This occurs when, in the absence of consensus and approval, owners fail to settle on a collective resolution. An extended deadlock period can lead to prolonged and costly periods of adjustments, missed opportunities and significant financial losses. If direct negotiations or mediation efforts ultimately fail to resolve a clash where the business does not have some form of agreement, then the last resort is legal action. The aggrieved partner has the option of bringing the case to court to claim her rights, to seek some form of relief, or to formally wind up the company. The major downsides are that litigation is expensive and the parties will have no control over any final division of assets/resources made by the court—meaning an owner may not receive an equitable distribution based on the amount of work or time previously dedicated to the company.
It is of paramount importance for companies to have clearly articulated and explicitly drafted agreements to serve as guidance in the event of a dispute—regardless of how unlikely such a scenario may seem when forming the entity. This will effectively mitigate the risk of financial losses and significant time commitment associated with litigation.
Let Us Help!
It can be challenging to successfully navigate a strained business relationship, but LOVE LAW FIRM can help. Whether it’s drafting an effective foundational documents to prevent costly litigation, or providing reliable legal insight to aid in your decision making, our extensive business law experience and client-focused approach has established our firm as the go-to counsel for New York businesses. Contact us today to learn more about how we can assist you for all your business law needs!
Francine E. Love is the Founder & Managing Attorney at LOVE LAW FIRM PLLC which dedicates its practice to serving entrepreneurs, start-ups and small businesses. The opinions expressed are those of the author. This article is for general information purposes and is not intended to be and should not be taken as legal advice.