Although starting up a new business can be one of the most exciting accomplishments for an entrepreneur, the grim reality that the majority of new businesses, in fact, fail. Whether it is due to poor planning, failure to launch, lack of sufficient funding, or conflict among the founders, breaking up is sometimes the only option. Unfortunately, breaking up can be a bitter and painful experience for a variety reasons. Here is a roadmap of the issues that founders may encounter when divorcing with a partner, co-founder, or joint venturer.
Who Gets What? The biggest fight in a breakup of any business is often over who walks away with what. Most startups do not involve equal contributions by the founders, as founders often excel at different things, so the contributions are like apples and oranges. When founders contribute in different ways (labor versus investor connections versus “know-how” versus capital), it can be difficult to decide how best to split the baby. Obviously, no founder wants to walk away with an unequal share of the corporation’s assets. These problems can be exacerbated if a partner or co-founder wants to “restart” the business on their own or with a different team. For the co-founder being shut out, it can feel like being asked to leave your own birthday party.
What are the Company’s assets? Before the fight becomes too ugly, it is worthwhile for the company’s founders to take a carefully evaluate whether the company’s assets are actually meaningful. Is the company just starting out, or has it invested time, money, sweat, and received funding that have meaningfully contributed to its assets? For startups, there is often not enough at stake in the company for an expensive fight to ensue over how the company’s assets should be divided. That is not always true for well-established businesses, who may have invested in equipment, tools, or other assets, or have some sort of customer/client base already. Unless meaningful assets are at stake, it will often be more costly fighting over them than simply parting ways as quickly and efficiently as possible through an agreement to dissolve the entity and simply distribute whatever assets exist among shareholders. Timing is often key. Many states, including Delaware and California require franchise fees to be paid annually for active corporations. So, if the corporation is not operating or making any money, the end of the year is a good time for warring founders to find common ground in a mutual desire to avoid unnecessary governmental fees. Often, the looming shadow of taxes or other governmental fees can result in a favorable agreement being reached even despite sore feelings.
How Do Company’s Organizational Documents Address Breaking Up? Assuming that the Company has meaningful assets and a straight dissolution is not possible, feasible, or there are other relevant circumstances (such as factions or disputes between the founders by which one is being asked to leave), a review of the company’s organizational documents is necessary to determine what procedures will be operative when attempting to give one member of the team the boot. If the company’s organizational documents have special procedures in place, they will have to be followed. Problems can arise, for example, if voting structure in the organizational documents requires a supermajority to accomplish the necessary resolutions, in which case it may not be possible to accomplish certain tasks because there are insufficient votes or insufficient directors. On the other hand, if the company has a repurchase rights agreement in place or vesting schedule that applies to the founders, those documents can dramatically affect how shareholders/directors exit the company.
Protections for Minority Shareholders. Whether the corporation was formed in Delaware or elsewhere, there are legal protections given to minority shareholders of a company. So, if there is a dispute between founders over the direction of the company and the company wants to give a certain founder the boot, it is not as easy as showing him or her out the door. Under the law, minority shareholders can go to Court requesting, among other things, that the Court dissolve the corporation and award the shareholder his fair share. Often, the law provides for methods of calculating the fair share of the shareholders buyout price, which is often difficult to do in the private market.
Negotiated Break-up. Because it is often extremely expensive to get the judicial system involved in sorting out disputes among founders, it is often the easiest for a mutually agreeable breakup to be negotiated. Practically speaking, this does not happen often for the same reasons that divorces in marriages become ugly — there’s too much emotion, resentment, or other feelings driving decision-making. In this respect, having a mutually respected friend, consultant, business, or legal advisor to mediate differences and reach a mutually agreeable outcome is often the best way of handling it.
The Mechanics of Breaking Up. Once a resolution is reached on how to break up, there are a number of steps that must be taken to ensure that the breakup is clean and all assets are accounted for. It is not only the company’s bank accounts and liquid assets that must be dealt with, but also intellectual property, including ownership of patents inventions copyrights trademarks, and other intangible assets. The necessary paperwork must be prepared assigning all of the company’s tangible and intangible assets, and the necessary filings must be made in the state of the company’s incorporation. If the company is dissolving, rather than being subsumed into a new company through an asset purchase, reverse merger, or other type of transaction, necessary tax forms must also be prepared and filed with the IRS.
If your business is breaking up, don’t fret – all is not lost. Some of the most successful entrepreneurs went through many rounds of failure before striking gold. Often, it is only through trying and failing that vulnerabilities are identified and remedied. When divorcing with a co-founder, the key to a successful resolution is taking account of all of points of contention, and then methodically working through them to reach the best deal possible for both sides. Breaking up is never easy to do – but it does not have to be painful.
Rabeh M. A. Soofi is an attorney and advises businesses and startups throughout California.