California Business Divorce: Why Business Partners Split—and What to do About it in Your Operating Agreement
In many instances, an irreconcilable dispute leads business partners to break up, and sometimes end up in litigation. Even when owners get along great, life events such as failing health may force someone to depart the business.
While businesses are usually started with great optimism, it is crucial for business partners to engage in some "glass-half-empty" thinking to prepare for the possibility of a split. What's at stake if they don't? The ongoing existence of the business.
Without clear provisions spelling out what happens in the event of the departure of a business partner in an operating agreement (or equivalent agreement depending on the entity structure of the business), the default rules under, for example, the California Revised Uniform Limited Liability Company Act, will dictate the outcome, which may be undesirable.
It’s critical, therefore, to be proactive, understand some of the common reasons why business partners split, and plan for that possibility in an operating agreement.
Common Reasons Why Partners Part Ways
There are many issues that can lead to a breakup among business partners. Here are some of the most common (although by no means is this an exhaustive list):
- Disagreement over the direction or management of the business. From the allocation of resources, to the strategic direction of the business, to roles and responsibilities, irreconcilable disagreements about fundamental management decisions make it difficult for partners to continue working together.
- Change in personal circumstances. People want to retire. They deal with health issues. They may want to move on to pursue other business opportunities. Over time, the individual life circumstances and preferences of partners will almost certainly change.
- Financial difficulties. The financial struggles of a partner—caused by, for example, a bad personal investment—can prevent them from being able to contribute financially or operationally to the business.
- Lack of alignment. Partners can disagree about the company's goals and vision, or experience a lack of motivation or interest in the business.
- Breach of fiduciary duties. Whenever there’s money at stake, there’s a risk that a partner may seek to capture more of it, such as by clandestinely starting a competitive business and diverting opportunities to it. This leads not only to a breach of trust, but also a breach of a fiduciary duty.
- Disputes about compensation and distributions. Do salaries appropriately reflect the value being contributed to the business? Should profits be distributed or invested back into the business? Partners don’t always see eye to eye on these issues.
The starting point for limiting the negative impact of a business partner breakup is to anticipate the common reasons why it might happen. This allows partners and their legal counsel to create a well-designed operating agreement that leads to a better outcome.
Key Provisions to Include in an Operating Agreement
By anticipating worst case scenarios at the outset of a business relationship, partners can create an operating agreement that reflects their unique circumstances and preferences.
Buy-Sell Agreement. A buy-sell agreement outlines the process and terms for a departing partner to sell their interest in the business to remaining partners or an outside party, including the method to calculate purchase price, how payment will be funded, and sale contingencies, among other things.
Non-Compete Agreement. Many operating agreements require owners to enter into a non-compete agreement to prevent someone from departing the business and then competing with it. It’s important to note, however, that non-compete agreements are facing a possible ban by the Federal Trade Commission, although it’s not yet clear what the scope of such a ban would be.
Decision-Making Procedures. An operating agreement should specify the procedures for making decisions, such as the number of votes required to approve certain actions. This can help avoid disputes over decision-making and ensure that all partners have a say in important business decisions.
Management Structure. To prevent disputes over who is responsible for what and to ensure that everyone is clear on their duties, an operating agreement should define the management structure of the business, including the roles and responsibilities of each partner.
Capital Contributions. The operating agreement should outline the capital contributions required from each partner and the terms of those contributions. This can help prevent disputes over funding and ensure that everyone is contributing fairly to the business.
Dissolution and Successor Provisions. Some business partners decide that, under certain circumstances, the business will be dissolved following a partner’s departure. If that’s the case, the operating agreement should address when and how a dissolution should occur, including how assets and liabilities will be dealt with. In other situations, where the business will continue operating, a successor provision can set forth the process for adding a new business partner and any approval rights of remaining partners.
Dispute Resolution Clauses. Finally, an operating agreement should address how disputes between partners will be handled. Dispute resolution clauses should include the applicable governing law that the parties will apply to any disputes, and the steps required for beginning and enforcing the dispute resolution process. Such a clause can and should also set forth the manner in which partners will attempt to resolve their disputes, which may include negotiation, mediation, arbitration, and/or litigation. Instead of leaving things to chance, partners should think carefully about whether mediation should be required before litigation, what forum litigation should take place in, and other issues, and document preferences in an operating agreement.
To limit negative consequences from a breakup between business partners, regardless of whether it’s amicable or contentious, invest in a good operating agreement, communicate openly and frequently, and seek advice from trusted legal counsel. Although conflicts are inevitable, being proactive and carefully crafting an effective operating agreement can help a business thrive.
