JUST LIKE IN A MARRIAGE, no one at the outset of a closely held company expects things to go south and end in divorce. But just like in a marriage, the best time to address what will happen if things do not go as hoped is at the outset, when everyone is excited and working together.
Instead of a pre-nuptial agreement, shareholders in a closely held company will want to include provisions regarding separation in a written buy-sell agreement (sometimes called a shareholder agreement, member control agreement, etc.).
A good reason to plan for a separation in advance is that in business divorces where no agreement on separation exists, Minnesota courts look to the reasonable expectations of the shareholders.
In one landmark Minnesota case, the court awarded a minority shareholder both the value of his shares in the company and his lost wages for the remainder of his working life, as the court determined that those were the reasonable expectations of the shareholders in forming the company.
To avoid a court determining what the original reasonable expectations of the shareholders were years later, shareholders should strive to eliminate confusion by spelling out the reasonable and agreed-upon expectations in a buy-sell agreement.
Terms to include in buy-sell agreement
A comprehensive buy-sell agreement plans for all types of contingencies with regard to the transfer of shares. This includes planning for the death, divorce, or bankruptcy of a shareholder, and what to do when a shareholder chooses to sell shares. A comprehensive buy-sell agreement should also contain terms concerning what will happen if the shareholders come to an unresolvable impasse, including:
- Deadlock —The buy-sell agreement should contain a description of what constitutes an unresolvable deadlock and the process for determining that such a deadlock has occurred. Further, the buy-sell agreement should include what is to be done when a deadlock is reached, including whether a shareholder needs to sell his or her shares.
- Valuation —Oftentimes a buy-sell agreement will include a manner in which the company is initially valued, and then will include a term regarding an annual renewal of the valuation. Unfortunately, because it requires a meeting, evaluation, discussion, and agreement, our experience is that the annual valuation rarely occurs, as shareholders find it burdensome when no sale is imminent.
So, a buy-sell agreement should include a term regarding the valuation of shares upon a transfer, whether that be through a formula, an agreed upon price, or through the selection of a trusted outside valuation expert.
As an example, some buy-sell agreements will allow the company and the selling shareholder to each select their own valuation expert, then the two selected valuation experts will choose a third person to serve on a three-person panel that will work together to determine the value of the company.
- Dispute Resolution —If the shareholders wish to avoid protracted litigation that may end up in court, they will include a provision regarding the steps they must take to resolve disputes. The first step is often the discussions the shareholders must have together to resolve a dispute. Should that fail, the next step is generally a mediation requirement, which will also include an agreement on how the shareholders must select a mediator. Should all of this fail, most shareholders nowadays prefer arbitration as opposed to the court process. The reasons for this vary, but arbitration allows the parties to select a qualified arbitrator with experience in business disputes. Of course, the courtroom is always an option for resolving disputes between shareholders should an alternative process not be agreeable.
A comprehensive buy-sell agreement that spells out the reasonable expectations of the shareholders reduces the likelihood that the optimistic start of a business will result in protracted litigation.
Steps to take when divorce is forthcoming
Of course, just like in a marriage, some disputes cannot be overcome and divorce is the necessary path. When divorce is likely, here are a few steps for a shareholder to take:
- Talk to an experienced commercial litigation attorney —Nothing will help you sort through the options and prepare you better for litigation, if necessary, than someone who has been there before. One thing to keep in mind, though, is that the attorney that set up the company and drafted the buy-sell agreement represents the company and not the shareholders and will likely have a conflict in representing any of the shareholders in a dispute. That attorney would likely be disqualified under the professional rules of ethics from representing any of the shareholders individually.
- Avoid unnecessary communications — While this can be tricky when shareholders are trying to work things out amongst themselves, this is also the period when parties are most likely to make statements that can be held against them during litigation. The best way to avoid that is to communicate with the other shareholder only when necessary, and to document every such communication as thoroughly as possible.
- Preserve documents — After speaking with you, the next thing your attorney will want to do is review important company documents. On top of this, a party to any potential legal dispute should take steps to retain any documentation, including electronic files and communications. This is critical because if you are found to have caused the loss of necessary documents, a court can limit your ability to present evidence or even dismiss your claims or defenses.
- Attorney fees — Litigation is expensive. All parties to a lawsuit know this. And while Minnesota statutes, or even the buy-sell agreement, might allow for a shareholder to recover attorney fees if successful in the litigation, such recovery of attorney fees is not assured, and even when awarded, is usually far less than the actual attorney fees expended. If a business divorce is forthcoming, be prepared to spend significant money while anticipating little chance of recovering attorney fees.
No one wants a business to end in divorce, but like most things in life, the best way to deal with a business divorce is through good preparation.
