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| 4 minutes read

Till death do us part? 5 legal issues to consider before a business divorce.

In many ways starting a business with someone is no different than entering into a marriage. Both involve a partnership where individuals share their hopes, dreams, and assets with one another. Both require work, a shared vision, communication, and trust. And much like marriages, many don't end up as planned. 

It is no surprise that inflation and current economic pressures are putting added stress on marriages and businesses alike--demanding that we all do more with less. Over time the pressures of managing dynamics like this can lead to an erosion of communication between founders. If founders are not aligned in their vision and values this can ultimately result in degradation of of trust. Once that trust has eroded, repairing the relationship between founders is incredibly difficult. At this point, the parties may have no choice but to go their separate ways. 

Navigating that departure can be complicated, time consuming, and ultimately expensive. Before taking action on separating, founders would be wise to consider these five common legal issues that arise in business divorces:

  1. Governance. Any attorney will tell you that when a business is founded it is important to ensure that the company has proper formation and governance documents. Unfortunately, with the proliferation of commoditized legal service platforms like Legal Zoom and Rocket Lawyer, many founders overlook important components such as operating agreements and bylaws. These documents can impact everything from voting, control, transfer, and even when and how a meeting is called. These can all be incredibly important provisions to understand as you consider taking action to leave a business. A lack of proper governance can result in stalemates and the inability to take action--undermining the ability to move the business in any direction despite what may be a growing conflict. This may leave dissolution as the only option unless a negotiated departure can be reached.

  2. Buy/Sell Agreements & Transfer Restrictions. The presence of buy/sell agreements and transfer restrictions on a founder's equity can greatly impact options when deciding to exit a business. Depending on the terms of these agreements, this may provide for an orderly and clear process for exiting, or alternatively prohibit a founder from transferring their equity altogether. It is important to have a clear understanding of any agreements and their impact on your plans. 

  3. Non-Compete Agreements & Restrictive Covenants. Even if a founder is able to exit the business, they may still have restrictive covenants that constrain their ability to take certain actions or pursue certain business interests after leaving. Non-competes, non-solicitations, non-disparagement clauses, and non-disclosure agreements all will impact the options of a founder both while they are with the business and after they exit. Non-competes in particular will likely limit the ability to compete in the same industry or market after separation. While New York courts will generally be hesitant to enforce non-compete agreements against many employees, the same generally is not true with business owners--meaning that non-competes are a risk that cannot be ignored.

  4. Fiduciary Duties. Generally speaking directors, managers and partners will owe fiduciary duties to the business and their counterparts. These fiduciary duties are intended to encourage founders to act in the best interest of the company and each other by imposing a duty of care, a duty of loyalty and a duty of good faith and fair dealing. Part of that includes not usurping opportunities of the company and enriching oneself personally. Issues often arise here when a founder makes the decision to leave and effectively starts competing with the business before they actually depart--deciding to pursue opportunities in their personal capacity instead of through the business. Often founders feel justified in this behavior given how toxic the business relationship has become. Despite whatever justification a founder may feel, failure to comply with their fiduciary duties can result in not only liability and damages to the business, but also a court imposing injunctive relief, restraining orders, and a constructive trust over any ill-gotten profits. Suffice it to say these remedies can have a crippling effect.

  5. Ownership of Intellectual Property. A company's intellectual property ("IP") can be a primary source of its value. This is especially true in technology companies and those with significant IP portfolios. Generally speaking if a founder creates IP, ownership of that IP will exist with that founder personally, not the business. This is why it is crucial that founders execute IP assignments when setting up their business. Unfortunately, founders can often overlook transferring IP to the business. Understanding who actually owns the IP can be a crucial part of a business separation. If one founder personally owns the company's IP it can significantly impact the relative leverage in a business divorce and the consideration paid for any equity.

This is by no means an exhaustive list of issues that founders will face in contemplating a potential exit from a business--especially if it is contentious. Indeed, in addition to legal issues, an owner will often have to consider liabilities, public relations, and the personal stress and anxiety of going through the process. Still, if the business relationship is no longer tenable, then it may be time to consider your options. Making sure you understand all of the potential issues and have a proper strategy is crucial to exiting with as little pain as possible. And if you are just getting started, proper business, legal, and strategic planning at the outset can help mitigate some of these issues when the time comes. Just like with a marital divorce, you don't have to--and shouldn't--go at it alone. Make sure you have the right professional advisors to help.

In many ways starting a business with someone is no different than entering into a marriage. Both involve a partnership where individuals share their hopes, dreams, and assets with one another. Both require work, a shared vision, communication, and trust. And much like marriages, many don't end up as planned.