Tax & Business Insights


Deadlocks in Small Businesses :
Don't Assume Harmony

Volume 8 Issue 2 -- March/April 1996

Many business relationships, like other relationships, begin with the rosy assumption that there will never be a problem that cannot be resolved by reasonable people. Experience shows, however, that there are frequent cases of "deadlock" resulting in interminable friction or, even worse, litigation.

Some wags have described small business as a "marriage without sex." Problems inevitably will arise, and deadlock can result when the parties reach a point that they can no longer "kiss and make up."

Deadlock can arise when, because of persistent disagreements, no one owner or group of owners can effectively exercise control and make decisions, or a minority may have a virtual "veto" power over anything the business wants to do.

Often, preceding deadlocks there is a common pattern involving a new entity with little or no documentation between the owners. Often the business is initially successful, otherwise the business would never get beyond the formative stage.

Unfortunately, many small businesses in the formative stages don't care about business formalities and do not prepare formal agreements, corporate minutes, bylaws, and the like. (While we may use corporate terminology in this article, the same principles apply to partnerships, LLCs, etc.).

Far too often, attorneys and advisors assisting new businesses fail to advise commercial neophytes of the need to consider and document what will happen if, for example, one of two shareholders: (a) refuses to guarantee new corporate debt, (b) refuses to work full-time, or (c) dies or becomes disabled? The list of possible trouble spots can go on and on.

Perhaps the more common source of deadlock is simply the certainty that, over time, there will be disagreements. As in marriage, people and situations change and mature over time. Most businesses' disagreements can be resolved, but some can't, and when the differences cannot be reconciled, deadlock may ensue, particularly with two equal (50-50) owners.

After the deadlock develops, the owners discover, to their horror, that they have ignored all documentation that could help resolve the deadlock. There are often no bylaws, minutes, or other agreements which could shed light on how decisions can be made and problems resolved.

Surprisingly often, there are disagreements about who owns how much stock. (Tip, if an "S" election has been filed, IRS Form 2553, an answer to stock ownership questions may be found in that form)

Plan for Tomorrow

The overriding message of this newsletter is to prepare documents, now, controlling ownership and how meetings and specific problems will be handled. Potential problems and foreseeable events (e.g., death and disability) need to have a mechanism for resolution. How many times have you heard the distressed middle-aged person state that a pre-nuptial agreement is a good idea, only after he/she has begun the woeful unraveling of a second or third failed marriage?

Most small businesses need some or all of the following planning devices, regardless of whether its a corporation, partnership, or LLC, although the precise terminology may change:

(1) Stock certificates or other clear records of ownership to establish ownership and control.

(2) Bylaws (or a partnership agreement or LLC operating agreement), which are similar to a constitution or charter and are used to define and describe basic operating functions and procedures, such as how many are needed for a valid meeting and what percentage of agreement is needed to approve a matter. Without these basic governing devices, when there is disagreement the parties usually cannot agree as to how, or in what manner, they will resolve it.

(3) Buy-Sell agreements (sometimes called stock redemption agreements), which can be used to address the consequences of events like death, disability, retirement, or the termination of employment of an owner. Often, such agreements will also include "covenants not to compete" or nondisclosure provisions designed to prevent the departing business associate from taking customers or business knowledge and using it in an impermissible manner.

Whether you have all, or some, of the above mechanisms will depend on the owners and their willingness to think about "tomorrow," before an important entity-splitting decision is thrust upon them.

Assuming all else fails and the owners remain at loggerheads, there is the judicial system. Most states have some form of judicial remedy to remove the impasse. Often these remedies, like "judicial dissolution," are nothing more than orderly death to the business. Litigation growing out of deadlock, like divorce proceedings, is usually not so much a solution to the problems but rather a way to sidestep them and terminate the relationship. And, like divorces, these legal options often turn bitter, as the business disagreements fester into personal animosities.

Think about tomorrow! Don't allow your business relationship, or those of your clients, to go unattended.



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