It is rare to find a business partner who is selfless. If you are lucky, it happens once in a lifetime.
– Michael Eisner, Chairman and CEO of the Walt Disney Company from 1984 to 2005
Starting a company with a best friend or family member may sound like a great plan, because these new partners share a high level of trust and a close personal relationship, as well as excitement over launching a new business. These co-founders foresee no problem in forming the company as a 50-50 split in which they expect to share equally in the company’s ownership, management and control. In this heady state of forming a new company, akin to the bloom of a new romance, it may seem off-putting to consider and address a potential future ownership break-up in which one of the partners leaves the business.
But as former Disney CEO Michael Eisner notes, finding a selfless business partner is exceedingly rare, and the more likely result is that a serious rift will arise in the partners’ business relationship in the future. It may be caused by a divorce, an unexpected illness or a change in business priorities that develops over time. But realistically, the question is not “if,” but “when” a disagreement will arise, and how the business partners will handle this conflict and the potential need for them to participate in a business divorce. The failure to acknowledge this risk at the outset and then address how to manage a deadlock or to structure the company to enable an amicable separation can result in significant cost to the partners and the business.
The Basic Problem with the 50-50 Owned Business
When management and control of a private company are split 50-50, all significant business decisions require both partners to consent to the proposed action. This need for mutual agreement by both owners can easily lead to an impasse in business operations. There are many issues that can lead to conflict, but some of the more frequent disagreements we have seen include the following: (i) whether to admit new shareholders or LLC members who will dilute the ownership percentage held by the founders, (ii) whether to take on new debt, (iii) whether to hire/fire new officers and managers, (iv) whether to issue dividends/distributions or retain earnings, and (v) if distributions are made, the amount to be distributed.
Given the likelihood that conflicts will arise between the co-owners, the question then becomes, how can this impasse be overcome when there is no contractual means for resolving it. In Texas, there is no statutory remedy that provides an effective mechanism for breaking an ownership deadlock, but there are judicial remedies that can a partner can seek when the deadlock threatens to destroy the business.
Texas Law Addressing Ownership Deadlock
Under the Texas Business Organizations Code (“TBOC”), a court may appoint a receiver when the party seeking the appointment of the receiver can establish that: (i) there is a deadlock in the ownership of the company, (ii) deadlock exists in the management (“governing persons”) of the company, and (iii) the company is either suffering or threatened with irreparable injury because of the deadlock. Courts are understandably reluctant to appoint third-party receivers to preside over an operating business because this appointment puts the court squarely in the cross-hairs of running the company.
Further, courts also recognize the extensive case law holding that that the appointment of a receiver is a drastic (sometimes referred to as “draconian”) remedy that can have catastrophic results. For example, many contracts include provisions that the appointment of a receiver constitutes a breach of the company’s contracts with third parties, which authorizes these third parties to immediately terminate the contracts they have with the company. A common covenant in loan agreements often allows lenders to declare all outstanding loans to the company immediately due and payable upon the appointment of a receiver. As a result, the appointment of a receiver can render the company insolvent and, ultimately, lead to its dissolution.
Given the dire consequences that flow from appointing a receiver over a business, the TBOC requires a court to consider “all other available legal and equitable remedies” before appointing a receiver. This provision effectively directs courts to consider their equitable powers to find alternative routes of resolving conflicts that arise among business owners. For close corporations, the TBOC also allows the court to appoint a provisional director or custodian. While not expressly authorized by statute, a similar approach has been taken for limited liability companies, and courts have appointed a provisional manager or custodian to operate the business. This appointment may resolve the conflict, but it places control of the business in the hands of an unrelated third party, who has no vested or economic interest in the business.
Structuring Company Ownership and Control to Avoid Deadlock
The best way to prevent a deadlock and the potential for court interference in the business is to avoid it in the first place. One sure way to avoid deadlock is to decide that ownership of the business will not be equally divided, but closely split, e.g. 51-49. Further, the company’s governance documents should specify the roles of the partners, designate their duties according to their expectations and make clear how decisions will be made on both day-to-day operations and more significant matters. So that the minority partner is protected, the governance documents can provide that certain fundamental decisions will require a super-majority approval—effectively giving the minority owner blocking power in certain circumstances. Further, in limited liability companies, an unequal split of control and management does not mean that the co-owners cannot split profits equally—the owners can provide for control of the business to be allocated on a 51-49 arrangement while still agreeing to split profits equally on a 50-50 basis.
If the partners are determined, however, to adopt an equal, 50-50 split of both management and control of the company, it is imperative for them to create a structure that is clear and effective in managing disagreements in a way that resolves disagreements and avoids deadlocks. Putting a dispute resolution process in place at the outset can help preserve the relationship between partners and prevent unnecessary disruption in the business. The freedom of contract permits the co-owners to put a myriad of creative solutions in place that will manage deadlocks, subject to certain statutory and reasonableness considerations.
The parties can agree to resolve their disputes by a coin toss if they choose, but for less random/flippant solutions, the following options exist:
Appoint a tie-breaker. The company’s governing documents can require disputes to be resolved by a tie-breaker, such as a non-owner CEO, board, advisory board, or committee. It is important to consider the independence of any party designated as the tie-breaker, however, because if this party is controlled by one partner, the other partner may be out-maneuvered. In lieu of an affiliated party serving as the tie-breaker, the partners can appoint an independent third party or “provisional director/manager(s)” in the governance documents to resolve conflicts. This would be a trusted but impartial third party, who would receive immunity from suit by the partners for matters relating to this party’s role in the decision making process. If specific tie-breakers or provisional directors are not named at the outset, it is important for the governing documents to clearly delineate the mechanism for how a tie-breaker/provisional director will be selected (or replaced, if the original selection is no longer available/willing). Appointing a true, independent third-party tie-breaker takes the decision making authority out of the hands of the partners and therefore raises similar concerns to a judicially appointed custodian. As a result, using a provisional director may not be ideal for certain major decisions—such as selling the company or issuing stock, etc.—and should limited to use with more “day to day” disagreement.
Appointing experts. Depending on the nature of the dispute, an outside advisor or consultant can be hired to resolve a dispute. If there are “market” or “best practice” considerations for certain matters, an advisor or consultant can issue a report that will bind the partners. This avenue may be useful for resolving disputes relating to executive compensation, stock option plans, human resource matters, etc.
Require alternative dispute resolution. Mandating mediation can be a fast and inexpensive route to resolving a conflict to help get the company back to business. But, mediation is not binding and may not resolve the conflict. An arbitration provision can therefore also be included in addition to (or in lieu of) mediation. If mediation fails, the parties can move to arbitration for a binding decision. Arbitration can be both time-consuming and expensive, however, and may not be the best option for resolving pressing conflicts with immediate impacts on the business. This can be addressed to some extent by including “fast-track” arbitration provisions for resolving specific conflicts. A fast-track arbitration allows the partners to designate in advance the issues requiring arbitration, the presiding arbitrators, the scope of evidence allowed, and the timeframe for arbitration. This can result in a speedier, more cost-effective resolution.
Incorporate a buy-sell provision. Although the company may still be quite profitable, the partnership may be no longer be viable. In these situations, a deadlock may best be resolved through a business divorce achieved through a buy-sell provision. We have written about buy-sell agreements in previous posts, but at its most basic level, a buy-sell provision allows one partner to sell his or her equity to the other partner, or purchase the other partner’s equity. There are numerous ways to structure a buy-sell arrangement—for a more in depth discussion on buy-sell arrangements, see here. Triggering a buy-sell and forcing a partner out of the business can be a last resort when there is a true breakdown in the relationship of the partners. On the flip side, a buy-sell provision, even if not used, may serve as a catalyst for finding other avenues to resolve the conflict. The threat of a partner pulling the trigger on a buy-sell provision will loom in any deadlock, and incentivize both of the partners to work together towards an amicable solution that resolves a deadlock while keeping the partnership and business intact.
The 50-50 company ownership idea is one that often sounds good in theory, but in practice often results in major problems for both partners. The best solution is to avoid the problem entirely by deciding at the outset not to provide for equal ownership, management and control rights. If the partners are determined to implement the 50-50 owned and managed company model, however, they are well-advised to give careful consideration to establishing clear, binding procedures for resolving conflicts between them that will avoid future deadlocks in the operation of their business.
All business owners, and not just those who have 50-50 ownership structures, should include a buy-sell agreement in their governance documents or in a separate agreement. Few business partnerships last forever, and including an exit strategy at the outset will likely save the partners heartache, as well as huge legal expenses, when it comes time for one of the partners to depart from the company.