This is the eighth article in a 10-part series exploring legal mistakes that can be fatal to a business, even a seemingly well-established one. The illustrations and guidance provided are designed to help you spot these mistakes early. Each of these mistakes is preventable with proper planning and preparation.

Last month, I discussed the dangers of failing to implement restrictive covenants with employees and contractors. Properly drafted, enacted, and enforced restrictive covenants help you minimize the possibility of unfair competition when employees leave your business and help protect the intangible goodwill and proprietary information that makes your business successful in the first place. Non-solicitation agreements prevent former employees from contacting your customers and staff after leaving your company; confidentiality agreements protect your trade secrets and other confidential information; and narrowly tailored non-compete agreements can protect your legitimate business interests after the departure of a key employee.

So, you’ve taken the steps to properly incorporate, maintain, and segregate your business ventures and you’re using a registered agent. You’ve also taken the necessary steps to protect your business’s intellectual property, hire good people, and enact restrictive covenants. Congratulations, your business is well on its way to running along smoothly. But what happens if you and your business partner decide to part ways? Or what happens to your business if an owner goes through a divorce? This article will discuss how to avoid the devastating consequences of failing to establish a buy-sell arrangement.

Read on for an illustration of how easily mistakes can arise, how fatal they can be for even the most successful business, and how to avoid them entirely with dedicated planning.

All good things must come to an end. Successful businesses plan for this eventuality and decide up front how to terminate their business relationships before one of the owners wants out.

Karen and Stacy had operated their internet-based store for more than five years. Each of the women owned half of the stock in the company, with Karen handling the financial matters and Stacy focused on sales and marketing. They made a good team, and their business prospered for a number of years.

Though they had similar goals when they started the business, recently Karen and Stacy found that they no longer saw eye to eye. Stacy wanted to expand the merchandise available at the store; Karen felt it was critical to focus on their existing product lines. When they could not reach a joint decision, Stacy purchased new product lines over Karen’s objections. Karen retaliated by ignoring the invoices from the vendor until they went to collection and shutting off Stacy’s company cell phone. Their working relationship began to break down.

Each of them wanted to separate their business relationship, but they didn’t know how. Stacy said that she would sell her 50 percent of the business to Karen for $1 million cash. But Karen thought the business was only worth $1.5 million total. Their disagreement became more and more contentious. Ultimately, they refused to talk to each other.

In desperation, Karen filed a lawsuit to dissolve the corporation. Sales stalled and the value of the company plummeted as the two owners wrestled with their legal dispute. Some eight months later, after they had each spent more than $60,000 in attorneys’ fees and litigation costs, Stacy agreed to sell her interest in the company to Karen for $150,000. Each was bitter about the demise of the business; each felt that she had been cheated in the separation.

Another example is Geoff and Mark who had operated their manufacturing business for nearly 10 years when Geoff learned that Mark’s spouse was seeking a divorce. Because Mark started the business with Geoff after he had married, Mark’s ownership interest in the business was considered “community property” in his divorce. Mark’s spouse sought to keep 50 percent of Mark’s ownership interest in the business in the divorce, much to Mark and Geoff’s chagrin.

Unfortunately, even though Geoff and Mark had planned ahead for the idea that they may want to go their separate ways in the future, they had not planned for the idea that one of them might get divorced. Their company agreement was silent as to what should happen to business ownership in the event of a divorce.

Mark’s divorce became fairly contentious and the business was forced to participate in the litigation. Eventually, the court awarded Mark’s spouse half of Mark’s shares of the business. The business now had to figure out how to purchase those shares back from Mark’s ex-spouse or otherwise include his ex in all future ownership decisions. While Geoff and Mark’s business relationship remained strong, the divorce proceeding and its aftermath were substantially distracting and expensive.

Company agreements and bylaws not only govern how a business should operate, but they can also act as a form of “pre-nuptial agreement” allowing for the proper division of business assets among the owners should it ever become necessary. If you have business partners, it is strongly recommended that you establish a buy-sell agreement as part of your governing documents to address the transition of the business in the event one partner wants out or is forced to sell or transfer her ownership.

When people disagree about the value of something, the “seller” of the thing tends to believe it is worth more than the “buyer” and negotiates accordingly. This framing of the negotiation tends to encourage people to go too high or too low to assure the outcome they seek. Once one party puts in an “anchoring” number, the discussion changes and may not reflect the thing’s true value. Such positions breed disagreement when an owner seeks to leave a company and can often lead to litigation. Likewise, if a third-party (like a divorce or bankruptcy court) is forcing an owner to transfer their interests, the business may have little say in the process if not otherwise formalized as part of the company’s governing documents.

The simplest method for avoiding conflicts like this is for business owners to agree in advance on the proper method for how an owner can sell her interests and the proper valuation of those interests when sold. Such a valuation may be performed by the owners themselves or through the retention of one or more outside business valuation experts.

A buy-sell agreement typically addresses terms on which one owner can sell his interest to the other owners, setting forth the methods of calculating the purchase price and of establishing the terms of sale. Not only does it provide a mechanism for resolving impasses between owners, but it also provides an orderly way to handle the death, disability, illness, bankruptcy, divorce, or retirement of one of the owners. Among other things, a buy-sell agreement considers and addresses the following matters:

• When can an owner sell his interest in the business?
• Who is allowed to buy an interest in the business?
• Under what circumstances may an owner be required to sell her interest in the business?
• How will the parties determine the value of the interest in the business?

A properly drafted buy-sell agreement allows the ownership and management of the business to continue without having a departing owner’s successor forced on the remaining owners and can often avoid the business being pulled into unrelated court actions (be it divorce actions, bankruptcy proceedings, or otherwise). It also fairly compensates the departing owner for her interest in the business while still meeting the liquidity needs of the company. For complete protection, it is recommended that business owners’ spouses, if any, are parties to the buy-sell agreement as well.

Once the agreement is in place, you should review and update it regularly to ensure that it continues to meet your business needs.
In the next article, I’ll address the fatal mistake of a business failing to properly fund a buy-sell arrangement.

Erik G. Moskowitz specializes in civil trial law, including employment law, business law, and commercial litigation. He is well versed in corporate governance issues and assists and advises C-suite executives and managing directors on all manner of internal corporate policy. Moskowitz is also skilled at advising founders at start-up stage and positioning new businesses for growth while ensuring they’re insulated from risk. This article series was adapted from an e-book by Scott Gibson, Arizona, 2009.