Breaking Up Can—But Doesn’t Have to—Be Hard to Do: A Primer on Preparing for a Business Divorce

Business divorces, like regular divorces, come in all shapes and sizes. Some are amicable, and the parties are able to consensually resolve their split. Others are more adversarial, beginning with a disagreement over the direction or management of the business and later devolving into a knock-down, drag-out fight with various allegations of wrongdoing.

Whatever situation precipitated the need for a business divorce, there are four items that must be addressed before diving headlong into the process.

1. Determine Your Client's Objective

In all aspects of law, it is important to determine the client’s objective at the outset so the lawyer can craft a strategy to achieve that objective. In the business divorce context in particular, it is especially important for business owners to know where they want to go before their lawyers can help them figure out the best way to get there.

Business partners part ways for varied reasons. Amicable separations where one owner leaves while the business continues on, planned liquidations where the business simply closes its doors, and contested expulsions involving allegations of wrongdoing all are common scenarios that cause business owners to break up. Each situation has its own associated issues and complications that must be anticipated and then addressed in the process. Understanding why a separation is desired or necessary and what a business owner is seeking to achieve through the process dictates how to best approach the situation.

2. Know Your Client's Rights

It is remarkable how many businesses (large and small) operate on handshakes and mutual understandings instead of the agreements that they paid to have someone prepare when they started the business years (or even decades) earlier. If your client does not know whether the business has any formal governance documents, ask them to dig out the old corporate kit—it is probably black, with the name of the business embossed in gold lettering on the spine, and covered in a healthy amount of dust—and find out what is inside. If there are bylaws or a shareholder agreement (for a corporation), an operating agreement (for a limited liability company), or a partnership agreement (for, obviously, a partnership), then that is the starting point for assessing the parties’ respective rights and obligations. If not, then the governing state’s default rules for the type of entity at issue will typically apply.

The corporate lawyers and accountants who help business owners form their entities include these agreements in their formation packages for a reason—usually to protect the rights of the controlling parties who hired them to do the work. But oftentimes these agreements contain provisions that can be used to the advantage of minority owners who otherwise might think that they have little or no leverage in the situation. For example, the business’s voting provisions may require unanimous consent for actions such as bringing on a new owner or selling a major asset. If the majority owner wishes to take action that cannot be done unilaterally, then the minority owner’s blocking position becomes all the more valuable in negotiating an exit.

Business divorce lawyers can be extremely creative—and even dangerous—once they get their hands on these agreements, utilizing provisions that the business owners never even knew about to cause all sorts of mischief to advance their client’s cause. Understanding what these agreements provide at the outset of the representation is critical and will help avoid any unhappy surprises when engaging with the other side.

3. Understand the Financials

Understanding the finances and operations of the underlying business is one of a commercial lawyer’s most important tasks. When it comes to business divorces, irrespective of whether the company is making money hand over fist or teetering on the edge of bankruptcy, the company’s books and records (e.g., QuickBooks, financial statements, bank statements, and tax returns) tell the story. For help understanding what those books and records mean for a departing business owner, accountants are a business divorce lawyer’s best friend.

Accountants, like lawyers, have varied skillsets and expertise. Understanding the circumstances that led to the business divorce and what the client hopes to achieve in the process will inform whether and how one or more accountants can add value.

In hostile situations, such as where one business owner believes another is stealing or diverting business opportunities, engaging an expert forensic accountant early in the process is often critical to understanding the business’s true financial position, including untangling any complex transactions or structuring that otherwise may make it difficult to “follow the money.” In amicable separations that are unlikely to spark litigation, expert business accountants can help with a variety of issues that may arise in the process, ranging from differentiating between the value of the business as going concern and the value of a departing owner’s minority stake, to modeling the business’s future cash flows to assess the feasibility of a payout over time in a situation where the business will continue on without the departing owner. Even if the situation does not call for forensic accounting or business valuation expertise, the business owner’s personal accountant should be involved to help advise on the tax implications of any buyouts, write-downs, and other personal income tax issues that may come up and to ensure that any resulting transactions are structured in the most tax-efficient way.

Clients may be wary of adding another professional to the team, particularly at the outset of a representation. It is unquestionably an added expense but is usually worth it in the long run.

4. Ascertain Your Client's Exposure

Business owners often approach these situations thinking only about how much money they are entitled to for their stake. It is hardly, if ever, that simple.

Particularly in the context of contested expulsions, business owners are liable to fall prey to believing that the other owner is the only one with something to lose. Often that is not the case. Allegations of wrongdoing are typically met with allegations of wrongdoing. For example, when one partner criticizes the other for having his child on the business’s payroll and health insurance for a no-show job, don’t be surprised when your adversary responds by carrying on about your client’s use of the company credit card, and the car lease and cell phone for your client’s spouse that the company has been paying for years. Avoiding getting bogged down in what amount to trivial expenditures of which both sides are guilty is usually the better part of valor, but sometimes it is unavoidable. Always be prepared for a two-way fight.

Potential liability also lurks in amicable separations. Particularly in the small business context, company credit cards, bank loans, and leases often require personal guaranties from the individual business owners. Those creditors may not be inclined to release departing owners from outstanding liabilities, especially if the business is in financial distress. Remaining on the hook for the debts of an ongoing business over which you have no control is a risky proposition, and indemnifications are only as good as the solvency of the indemnitor. Eliminating all manner of risk is not always possible, but the departing business owner must understand the full nature and extent of that risk when making any final decisions on how to separate. Similarly, the lawyer needs a complete picture to include protections where possible.

Most important of all, it is crucial that the business owner try, as hard as it may be, to maintain a businesslike demeanor and remain focused on achieving the desired objective. Business divorces can be expensive, time-consuming, and extremely emotional ordeals for all the parties involved. It is far too easy for some business owners to get so wrapped up in the fight—wanting more than anything else to “win”—that the costs render even a successful outcome a pyrrhic victory.

****

Business divorces require a deep understanding of practically all aspects of commercial law, ranging from litigation and corporate governance to tax and restructuring. It is a full-service practice area that requires a full-service team. Lawyers and clients alike are best served by leveraging the expertise of a variety of legal and financial professionals so that the myriad issues that may arise in the process are thoroughly explored and addressed.