Corporate Divorce Can Be Messy, But Not for Those Who Are Prepared

While no one enters a partnership expecting it to end in divorce, no one is immune to failure. In the world of business, partnerships can sometimes mirror the complexities of personal relationships. Often, it is the “we’ve known each other forever” handshake partnerships that explode the loudest. When business partners decide to separate their interests, the process, often termed a “corporate divorce,” can be a maze of legal, financial, and operational challenges. This Insight aims to provide a comprehensive understanding of corporate divorce, offering practical guidelines to help navigate and prevent potential problems in this intricate process.

Understanding Corporate Divorce

Corporate divorce is a process where business owners disentangle their interests. This process typically unfolds in a series of steps. The initial stage often involves identifying and addressing immediate concerns. This could involve seeking legal measures to stabilize the situation, such as injunctions or restraining orders, or initiating discussions to resolve pressing issues. Ideally, the process would end here; however, more often than not, we live in an unideal reality.

The subsequent stage involves a thorough investigation into the claims at hand, which generally involves reviewing governing documents. This stage is where the groundwork laid during the formation of your business, such as clear financial protocols and decision-making processes, can significantly streamline the corporate divorce process. Governing documents can dictate the procedures for handling disagreements, the valuation of ownership interests, and the process for buying out a partner’s interest. When these documents are strongly drafted from the outset, they can provide a road map for navigating a corporate divorce, potentially saving time, money and stress.

The next stage is a critical one — this is the stage where the value of your business is determined. Those who pre-established a valuation method in their governing documents during the formation process (i.e., more peaceful times) can refer to such documents. Alternatively, divorcing parties may likely require the input of financial experts to provide financial analysis in determining an agreed-upon valuation method.

Finally, upon determining the value of the entity, the parties are closer to resolving the dispute, either through a negotiated settlement or through trial. Most corporate divorces end in settlement, which offers the parties more control over the outcomes; however, trials do occur when the parties have no meeting of the minds and, often, no governing documents.

Triggers for Corporate Divorce

The reasons for corporate divorce can be many, but some common triggers include differing approaches to financial decisions, contrasting visions of the company’s future and growth, and failure to adhere to corporate formalities. Each of these triggers can be mitigated by having clear expectations and procedures in place from the start, which can help prevent disputes from escalating into full-blown corporate divorce. Some expectations and procedures to clarify before you get into business with a partner include, without limitation, determining financial protocols and decision-making processes, thus reducing disputes over financial matters, as well as determining methods for handling disagreements over the company’s direction, such as mediation or arbitration clauses. By setting clear expectations and procedures from the start, these measures can help prevent disputes from escalating into corporate divorce.

Managing a Private Business in a Corporate Divorce

When a corporate divorce becomes inevitable, the next step is to determine the fate of the business post-divorce. The options available, such as selling the business and dividing the proceeds, one partner buying out the other, or continuing to own the business jointly, can often be influenced by the initial agreements made during the formation of the business.

A. Buy/Sell Considerations

When drafting your governing documents, be sure to address the methods for valuing the business and the terms for a buyout. This can include considerations such as:

1. Triggering Events. Identifying specific events that may trigger a buy/sell provision, such as retirement, death, disability, or a significant disagreement between partners.
2. Mandatory or Discretionary. Determining whether the buy/sell provisions are mandatory or discretionary is important in whether flexibility in exercising the option will be permitted or whether the buy/sell terms will be strictly adhered to, without room for negotiation.
3. Purchase Price Calculations. Establishing clear methods for calculating the purchase price, such as using a predetermined formula or relying on professional appraisals is critical to include in your governing documents, to minimize valuation disputes later.
4. Payment of the Purchase Price. Outlining the terms for payment, including timelines, installment plans, or the use of insurance policies to fund the buyout, providing a clear schedule from the onset.

B. Shotgun Buy/Sell Option

A shotgun-type buy/sell provision can be an effective tool in the event of a deadlock. This approach allows one partner to offer to buy the other partner’s interest at a specific price. The other partner must either accept the offer or buy the offering partner’s interest at that price. It can be a quick way to resolve a deadlock but requires careful consideration and drafting to ensure fairness.

C. Drag-Along and Tag-Along Rights and Right of First Refusal

When drafting your governing documents, it is essential to discuss concepts such as the right of first refusal, and/or drag-along and tag-along rights. These provisions can further define the relationships between partners and provide mechanisms for handling various situations that may arise during the life of the business. Drag-along and tag-along rights can play a crucial role in determining how ownership interests are bought and sold. Drag-along rights allow majority shareholders to force minority shareholders to join in the sale of the company, ensuring that the sale is not blocked by a small minority. Conversely, tag-along rights protect minority shareholders by allowing them to join a sale initiated by majority shareholders, ensuring that they receive the same price, terms, and conditions. These rights can be instrumental in facilitating a smooth transition of ownership and protecting the interests of all shareholders. They are typically outlined in governing documents and can be a vital tool in managing a private business in a corporate divorce.

D. Deadlock Resolution

In a corporate divorce, all parties should have legal representation to protect their respective positions and interests. However, the presence of clear guidelines for resolving disputes, potentially reducing the need for litigation (i.e., legal fees), can often simplify the legal process. For instance, if there’s a deadlock in decision-making, as discussed above, governing documents can provide procedures for breaking the deadlock, including bringing in a neutral third party, setting voting thresholds, or referring the matter to binding arbitration. By providing clear, agreed-upon procedures for handling disputes from the start, you can protect all parties’ interests, ensure a fair resolution, and minimize your legal fees.

E. Legal Remedies

Legal remedies may become necessary to resolve disputes or facilitate the separation of business interests, especially when the above-mentioned provisions are not well thought out or addressed in a company’s governing documents.

1. Judicial Dissolution. Judicial dissolution is a legal process where a court may dissolve a corporation or partnership if the parties involved cannot agree on a resolution. Judicial dissolution may be sought when there is a deadlock among the directors or shareholders, or when there has been misconduct or mismanagement. The court will typically review the governing documents, the conduct of the parties, and the best interests of the company before ordering dissolution. This remedy can be both powerful and drastic, effectively ending the business entity.
2. Alternative Dispute Resolutions. Before resorting to judicial dissolution, parties may explore alternative dispute resolution methods, such as arbitration and mediation. These processes can be more collaborative and less adversarial, potentially preserving business relationships. Depending on the terms of the governing documents, arbitration can be binding, with an arbitrator’s decision enforceable in court.
3. Injunctive Relief. In some cases, a party may seek a temporary restraining order or an injunction to prevent certain actions that could harm the business. This might include preventing the sale of assets, unauthorized expenditures, or other actions that could negatively impact the business during the divorce process.
4. Breach of Fiduciary Duty Claims. If one party believes that another has violated his/her fiduciary duties to the company, that party may bring a “breach of fiduciary duty” legal claim. This could include situations where a partner or director has acted in his/her own interest rather than the company’s interest.
5. Negotiations and Settlement. Often, legal remedies begin with negotiation and attempt to reach a settlement. Well-drafted governing documents may help expedite this process, providing a clear road map to take, in the event of disputes.

The choice of remedy will depend on the specific circumstances of the corporate divorce, the governing documents, and the laws of the jurisdiction. Engaging experienced legal counsel early in the process can help guide the parties toward the most appropriate remedies for their situation.

Conclusion

Navigating a corporate divorce can be complex and challenging. However, with the right legal advice, a clear understanding of the process, and a solid foundation laid during the formation of the business, business owners can ensure that their interests are protected and that the impact on the business is minimized.

The goal of a corporate divorce, much like a personal one, is to ensure that all parties can move forward and continue to thrive in their respective endeavors. The importance of having clear expectations and procedures from the outset, embedded in the business’s foundation, cannot be overstated. Your governing documents will serve as a vital tool for preventing disputes, guiding the divorce process, and protecting all parties’ interests, ultimately ensuring the business’s longevity and success.

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This DarrowEverett Insight should not be construed as legal advice or a legal opinion on any specific facts or circumstances. This Insight is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. The contents are intended for general informational purposes only, and you are urged to consult your attorney concerning any particular situation and any specific legal question you may have. We are working diligently to remain well informed and up to date on information and advisements as they become available. As such, please reach out to us if you need help addressing any of the issues discussed in this Insight, or any other issues or concerns you may have relating to your business. We are ready to help guide you through these challenging times.

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