Founding a business with a partner is similar to getting married in many ways; it is a long-term commitment with your financial future and livelihood at stake. Unfortunately, business partners often stop getting along at certain major inflection points of a startup’s journey. Sometimes partners have irreconcilable differences of opinion over critical decisions for the business, such as whether to seek outside investors or funding, bring on new partners, or enter new lines of business or markets. In other situations, personalities clash, or one partner loses interest in the business but does not want to give up any control or financial benefits. When such issues arise, founders often seek to separate, with one or more partner selling their ownership interests either back to the other partners or to a third party.
Startups and other closely held businesses face unique challenges when their founders need to separate because the partners’ interests are not easily valued or sold. There is no public market for a separating founder to sell their ownership interests, and the remaining partners do not want an unknown third party stepping into their ownership group. Considering the potential that your relationship with co-founders could break down at the outset of your venture will save significant time, money, and stress if a separation becomes necessary.
The Power of a Well-Drafted Operating Agreement
The best protection founders can have to ensure that a business separation causes limited interruption to the company’s operations is a carefully drafted operating agreement that contains provisions to allow for a separation without lengthy and expensive litigation. This includes “buy-sell” provisions, which allow one partner (the offering partner) to make a buyout offer to another partner (the receiving partner), with the receiving partner having the option to either sell their interests to the offering partner or buy the offering partner’s interests at the specified price. This provision is particularly useful where there are two founders whose relationship has eroded to the point where they can no longer effectively operate the business together. A well-drafted buy-sell provision can provide for a mechanism to remove one of the founders without litigation or a drawn-out business valuation process, limiting or avoiding turbulence for the business.
Strong language to allow for a smooth process for separation of founders in the event of dispute is also likely to make a startup more attractive to outside investors. Below are some of the benefits of having a well-drafted buy-sell provision in your corporate documents, as well as some of the potential pitfalls if an ownership dispute arises without a clearly-defined process for separation.
Benefits of Having Buy-Sell Provisions
- Smooth founder exits: Provides a clear, pre-agreed process for separating and valuing ownership interests when co-founders can no longer work together.
- Preserves business continuity: Reduces the risk of operational disruption during ownership disputes and departures of a founder.
- Prevents unwanted ownership transfers: Gives existing owners (including investors) the right to buy out a departing partner before unknown outsiders are brought in.
- Avoids litigation: Minimizes expense and delays with achieving separation by defining exit procedures, valuation formulas, and timing in advance.
- Maintains control and alignment: Ensures the ownership group remains aligned with the business’s vision and values.
- Protects investor confidence: Signals strong governance, which can reassure potential investors or lenders.
What Can Go Wrong Without Buy-Sell Provisions
- Costly legal battles: Disagreements over the terms and process for a business separation can escalate into expensive, time-consuming litigation.
- Business disruption: Internal conflict between founders can paralyze decision-making and stall company growth.
- Unwanted third-party ownership: A departing founder may sell their interest to an outside party, introducing misaligned or disruptive new owners, potentially affecting market valuation of the business.
- No clear valuation method: Without a predetermined process, parties may clash over how to value ownership interests, further delaying a resolution.
- Deadlock in 50/50 partnerships: If co-founders can’t agree on a path forward, the company could be stuck or forced into dissolution or a court-appointed receivership.
- Uncontrolled exits: A founder could leave at the worst possible time with no structured transition plan, jeopardizing client relationships, financing, or operations.
For companies that have several founders, operating agreements often include provisions that set a process for voting out or removing a disgruntled founder when business or personal disagreements necessitate a separation. These provisions can contain a stipulated process for valuing the departing founder’s ownership interests to be purchased by the remaining founders. The most appropriate provisions for providing a streamlined separation of founders will depend on the company’s legal structure, place of registration, and cap table. An attorney experienced in handling business separations can assist you with drafting enforceable separation provisions tailored to your business goals.
Conclusion
Many founders do not want to invest time and resources into having a well-drafted and thought-out operating agreement prepared at the outset of their venture. It is understandable that founders would prefer to focus their efforts on growing their companies rather than thinking about potential future disagreements; however, preparing a well-drafted operating agreement early on can be a major asset to your company in the event the founders stop getting along.
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