Business Divorce - Considerations before Beginning and Ending the Relationship
Originally published on the Mississippi Business Journal, April 19, 2021
In what could be considered a silver lining in a challenging year, Mississippi led the nation in new business formations in 2020.1 Whether this development was generated out of adversity or opportunity, much excitement, courage and anxiety have undoubtedly been experienced by the new business owners behind this movement, much like a newly married couple.
Many of these new businesses are closely-held, having just two or three owners. "Everyone will look out for each other," they say. "Things are going to be great!" they say. We expect that to be their viewpoint. After all, very few individuals walk down the aisle thinking the relationship will fail.
Unfortunately for many, we know otherwise. Similar to a marriage, untethering from a business can be a very complicated matter. If you find yourself contemplating the start of a new business or in need of a business divorce, below are five (5) points to consider concerning your rights and obligations.2
Pre-Conditions to Exiting a Business Relationship
In a tense separation, consent of all members to any action may be unachievable. This highlights the importance of giving careful attention on the front end in an ownership agreement to the rights of an owner to withdraw.
Owners leave a business relationship for many reasons, some involuntary and others voluntary. Involuntary withdrawal may include an owner's death, incapacitation, critical illness, bankruptcy or breach of duties owed to the business. Voluntary withdrawal should contemplate placing parameters around when an owner may withdraw otherwise. Whether a business partner leaves voluntarily or involuntarily, the ownership agreement should include the exit requirements.
A withdrawing owner should keep in mind that the ownership agreement may require that certain notices be given timely as pre-conditions to withdrawal.
Fair Distributions and Compensation
The best way to define an appropriate distribution is in the ownership agreement. Otherwise, depending on the type of entity, Mississippi law may only provide for a distribution upon the withdrawal of an owner or upon winding up of the business.
It is common for one or more owners to take a more active role in the day-to-day affairs of the business. Owners should consider compensating the manager/officer owner for his or her services at an agreed-upon amount outside of ownership distributions to avoid any inequalities.
Regardless, a common cause of ownership separation is when an owner misappropriates business funds or fails to make proper distributions to other owners. Claims against the breaching owner(s) may exist for breach of fiduciary duties, breach of contract, for an accounting and for injunctive relief. The misappropriation of business funds may also support a claim for dissolution of the business.
Obligations of Loyalty
Entrepreneurs and business owners can often be involved in multiple business ventures. Therefore, it is important to specify in the ownership agreement that such ventures will not be a violation of any duty of loyalty owed to the business in question.
Many times, however, owners intend for each owner to adhere to a duty of loyalty. A breach of the duties of good-faith and loyalty to a business may give rise to the expulsion of the member or dissolution of the business.
Non-Competition and Non-Solicitation Covenants
Investing in new people, new services and specialized training is costly, and businesses often seek to protect this investment by having owners agree to not compete with, or solicit others to leave, the business after withdrawing.
Covenants to not compete and to not solicit are enforceable if reasonable in time and scope. Courts, however, view such covenants as restraints on trade and with heightened scrutiny.
Careful consideration should be given to the need to protect the interests of the business from competition from a departed owner. Appropriately crafted covenants can protect a business from devastating losses. On the other hand, an ambiguous or overreaching covenant is challengeable and possibly unenforceable.
The Valuation of a Buyout
One of the most disputed issues between owners going through a business divorce is the amount due to a withdrawing owner. Without an agreement otherwise, Mississippi law provides for a departing member to receive the "fair value" of the owner's financial interest.
Written provisions in an ownership agreement can outline the situations in which an owner is allowed or required to sell his or her ownership interest and how the value of such interest should be determined.
Even with a written buy-out provision, disputes over a buy-out valuation are common. Consulting with an attorney or a business valuation expert may be necessary.
As with personal relationships, clearly communicating and agreeing to certain parameters in a business can prevent common and costly disputes. Sometimes, though, the best pre-planning does not alleviate all disputes between owners. Fortunately, the law provides options for ending the relationship and retaining the right to recover damages in certain instances.
1. Mississippi Business Journal, "Mississippi Leads U.S. in New-Business Applications"
2. Since this article is written to address businesses generally, shareholders and members are referred to collectively as “owners,” and the controlling documents between owners are referred to collectively as an “ownership agreement.”