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October 22, 2021 | BusinessFrom the blog

Planning for and Navigating a Business Divorce as a Start-Up

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Andrew Ramstad

Associate Attorney

Business divorce — the departure of a business partner on either amicable or not-so-amicable terms.   Business splits can be particularly harmful in the case of a start-up; after all, the worst time for a business to undergo a split is when it’s trying to find its feet, and the departure of a partner can create instability which can scare off investors.  Particularly in the case of emerging markets like crypto or cannabis, the unpredictable nature of the industry can make launching a business all the more difficult.  Nobody anticipates that his or her business might split up. Planning for the possibility, however, is the best way to keep your start-up stable and growing.

The Impact of an Unplanned Business Divorce

Start-ups in particular can start haphazardly, informally, and grow quite suddenly given the right combination of circumstances.  Even an informal understanding between new partners to operate as co-owners of a business for profit can create a partnership organically, without a written or oral agreement.  These types of partnerships, without being formed to address a specific goal or operate for a length of time, are called partnerships “at-will.”  Partnerships can be for either a specific length of time (a partnership “for a term”) or dedicated to accomplishing a particular goal (a partnership “for a specific undertaking”) and will generally be subject to New York’s default partnership laws and rules regarding splitting profits and losses, the effect of a partner leaving, or how the business can wrap up.

For example, partners can leave a partnership at will at any time simply by expressing their intention not to proceed with the business.  However, a withdrawal like this will cause the business to go through dissolution.  During dissolution, the partnership will continue, but only for the purpose of winding up its affairs and paying off creditors before distributing remaining profits or losses of the business among the partners.  Should the non-withdrawing partners wish to continue a dissolved partnership at will, they will need to create a new partnership to do so. 

The upshot of this arrangement is that if an unofficial partnership is formed between partners as a partnership at will, any partner wishing to leave can do so, and as a result dissolve the business and force distributions of any profits the business has at that point made (after paying off the business’s creditors).  Partnerships at will, therefore, are vulnerable if a partner gets cold feet or has the opportunity to cash in an early pay day after the business begins making money.  Partnerships at will are distressingly fragile in this way.

Document your Understanding and Plan for a Split

The easiest way to avoid a time-consuming, inconvenient business divorce is for business partners to document their understanding at the outset of their business venture together.  Even if they end up forming no entity, co-venturers should have a signed agreement that reflects, as a preliminary matter, what the business was formed to accomplish, how the business’s profits and losses will be split, under what circumstance partners are permitted to withdraw and whether or not they can force the business to buy out their interest.  These agreements might be overlooked as ‘mere formalities,’ but they are formalities that business owners can bring to a court to defend their company from a dissolution attempt by a disgruntled ex-partner. 

If business partners did not turn their understanding into a written agreement, courts in New York can still find that an oral partnership exists based on the conduct, intention and relationship between the parties.  If the co-venturers have an oral agreement in place addressing: (1) sharing of profits; (2) sharing of losses; (3) ownership of partnership assets; (4) joint management and control; (5) joint liability to creditors; (6) intention of the parties; (7) compensation; (8) contribution of capital; and (9) loans to the organization, then New York courts can find that the parties had a partnership even in the absence of a written agreement.  Delidimitropoulos v. Karantinidis, 130 N.Y.S.3d 831, 833 (2d Dep’t 2020) (citing Czernicki v. Lawniczak, 904 N.Y.S.2d 127, 130-131 (2d Dep’t 2010).

Court-held oral partnerships can still be created as partnerships at-will, and therefore be subject to the vulnerability of a partner’s exit.  To avoid that outcome, venturers should tailor their oral partnership agreement to direct their business to exist for either a “definite term” or a “particular undertaking.”  New York’s highest court, the Court of Appeals, has held that partnerships for a definite term need to be “durational … and refer to an identifiable termination date.” Gelman v. Buehler, 964 N.Y.S.2d 80, 82 (N.Y. 2013).  Similarly, partnerships for a particular undertaking require focusing on “specific objectives or projects” even if the termination date of completion is unclear.  Gelman, 964 N.Y.S.2d at 82.  This agreement should avoid focusing the venture on business activities that may continue indefinitely—in New York, those activities aren’t particular enough to constitute particular undertakings.  Id.

A court finding that a partnership was created for a definite term or a particular undertaking will then ensure that any business divorce caused by a departing partner will be considered wrongful withdrawal under the New York Partnership Law.  In that circumstance, the partnership business will be permitted to continue.  As the Court of Appeals held in 2018 while applying New York’s partnership law, when a partner commits wrongful dissolution in breach of a partnership agreement, that breaching partner is entitled by the law “to have the value of his interest in the partnership, less any damages caused to his copartners by the dissolution, ascertained and paid to him in cash …” See Congel v. Malfitano, 76 N.Y.S.3d 873, 881-882 (N.Y. 2018).  Notably, the Congel court also applied three reductions to the value of the breaching partner’s interest on top of the damages caused by the breach: the first, a reduction for the existing goodwill of the partnership, an intangible asset of the business determined by a factual finding at the lower court; second, a reduction in the value of the breaching partner’s interest based on the relative deficiency in marketing a minority interest in a business; and third, a discount applied to the interest to encourage investors to acquire minority ownership which will lack control of the business.  Id.

Of course, if the business partners have a written partnership agreement that contemplates a business divorce, then the co-venturers must follow the procedure specified in the agreement.  Failure to do so could be a breach of that agreement, and subject the departing partner to damages.  On the other hand, a partner who is squeezed out of a venture could also bring breach of partnership agreement claims against their co-venturers, depending on the circumstance.  New York courts are fairly permissive when it comes to written agreements that alter the Partnership Laws’ default rules—so long as the agreement in question does not permit action prohibited by the Partnership Laws or permit the partnership to act contrary to public policy, the Court of Appeals has said that parties can contract around the partnership law as long as they do so with clear language in their contract.  See Congel 76 N.Y.S.3d (N.Y. 2018).  Partners can even agree to permitting the prevailing party in a breach of partnership agreement action to be awarded attorneys’ fees, as the Court of Appeals explained in Congel.  Typically, prevailing parties in American courts cannot recover attorneys’ fees, but where the partnership agreement provides for their recovery—or where there are additional legal costs associated with correcting a breached partnership agreement—attorneys’ fees can be recovered. 

Better Yet, Create an Entity

Partnerships offer no protection for their partners for actions taken on behalf of the business.  This is because in a partnership arrangement the partners are personally liable for the debts and liabilities of the business.  In the case of a start-up, partners certainly want to avoid liability for personally paying back the contributions from investors if the business suddenly goes south, avoid being forced to wind up the business prematurely, or be forced to buy out a business partner after a sudden departure.  Where properly managed, an entity can limit the partners’ liability for corporate actions and decisions, to avoid paying entirely out of pocket to cover the debts of the company.

Forming an entity—a corporation or limited liability company (LLC), for example—creates a structure that is naturally predisposed to developing documentation to govern the relationship between the business’s founding members.  Corporations are generally governed by their shareholders’ agreements, bylaws and any resolutions passed by the shareholders or the board of directors.  Similarly, an LLC’s internal operations are governed by an operating agreement.  These documents can be as short and straightforward or as lengthy and detailed as the partners want.  Specifically, these documents should address when one of the business partners can leave, whether the company or the remaining partners will have a right to purchase the interest or shares of the departing partner, and how the company will value that departing member’s interest or shares if they elect to make that purchase.  In this way, operating agreements or bylaws create stability for your start-up and make sure that you set the terms on which partners will leave, as opposed to leaving the power to withdraw from a partnership in their hands.  Just like not following the procedures set out in a partnership agreement, a departing business partner not following the agreement could be liable to the company.

Creating an entity and having documented procedures in place to handle business operations and the potential for the withdrawal of a partner creates the same investor-perceived stability as a partnership agreement.  Knowing how a business will handle a departing member means less stress for the remaining partners and more comfortable predictability for your start-up’s investors.

Consult an Experienced Business Divorce Attorney

Whether a partnership has a founder back out of a venture at exactly the wrong time, or the other business owners are trying to force out one partner to take a bigger piece of the pie for themselves, business divorces are frequently anything but clean.  These splits can be especially disruptive to start-ups which need structure and predictability to encourage outside investment and launch a new business. Consulting with an experienced business attorney might not make these situations any less messy, but it can inject some predictability into the process and ensure that all parties know how the split will take place and how it will impact themselves and their business.

Photo by Romain Dancre on Unsplash

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