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Breaking up is hard to do: a less painful split in business

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Liberty School of Law


By Julia Rust

business-breakup_mainWhen I started practicing law, I knew I did not want to work in family law. So when I went into corporate law, I thought I had dodged a bullet. You can imagine my dismay when I realized that much of corporate law is just a “business marriage” and like other marriages, they frequently end up in a “business divorce.” Like newlyweds who never expect to get divorced, many new business partners fail to take necessary precautions in the early stages to avoid the damaging consequences of a potential falling out. These “honeymoon highs” can often result in some contentious lows because new partners don’t want to have the tough conversations, they trust each other completely, or want to push the deal through without rocking the boat.

A business breakup will always hurt, but there are preventative measures that can reduce the blow and some responsive measures to consider in order to stay in control and guide the dispute.

Preventative measures. A good set of governing documents can be a game-changer in these situations. A company’s operating agreement, bylaws or shareholder agreement provide the rules that govern the relationship among the company and its owners. Virginia’s Limited Liability Act and Stock Corporation Act provide a few options, but ultimately leave a lot open to litigation. Having an honest conversation about these matters at the start will help partners clarify their expectations, determine consequences for bad behavior and provide the framework for the final stages of their relationship.

Define what triggers a buyout. A breakdown in relationships among business partners does not always provide legal justification for forcing a buyout. If a partner refuses to sell, the company’s options are limited and they may be forced to seek dissolution if the partners are intent on splitting ways. Defining certain events that trigger a buyout offers a framework for the owners to work within and provides clear justification for making the call to move forward on the buyout. Common events include a partner’s divorce, bankruptcy, death or disability, retirement, termination of a partner’s employment or a deadlock in management.

Choose a valuation method. Most breakup disputes will largely center around the value of the business since that determines that value of an owner’s interest. The “value” of a business is not an exact science and can depend entirely on the methodology used to calculate it, as they each take different factors into consideration. Book value, discounted cash flow, capitalization of earnings, liquidation value — these all can result in widely varying valuations of the same business. Since both sides will be motivated to be on opposite ends of the valuation, this can frequently result in both parties hiring dueling experts to justify their valuation. A company’s governing documents can provide for one or two appropriate valuation methods that will dictate the negotiation process and limit the scope of the dispute.

Set the buyout terms. When negotiating a price, the objective is not just how much is paid, but when it is paid. When the company will continue to operate after a partner’s departure, put the company’s financial needs first. Although a lump sum payout is quicker and cleaner, it’s not always financially feasible. A company’s governing documents can set out the payment terms for a buyout that prioritizes the company’s financial health. For example, payments can be spread out over time or based off a percentage of monthly net income.

Motivate good behavior. There is nothing quite like the threat of a financial penalty to prevent bad behavior. When tensions get high, it can be difficult to control a partner’s conduct
that negatively impacts the business. A good buyout provision will reduce a partner’s buyout valuation for engaging in certain conduct such as competition, solicitating clients or violating their employment agreement or fiduciary duties.

Responsive measures. Unfortunately, many business partners do not have the foresight to negotiate a comprehensive agreement that plans out the demise of their relationship. Like marriage, most business partnerships start out in a honeymoon and they promise to support each other forever. Also like marriage, many business partnerships end in a divorce without a “prenup.” It’s typically more expensive and more difficult to navigate, but there are a few objectives to consider in guiding your client through the battle zone.

Consider the return on investment. Business owners’ priorities generally boil down to one of two things: their bottom line or their principles. For most small to mid-size businesses, attorney’s fees can quickly outpace the amount of money in dispute. Still, many owners are willing to fall on their swords for the sake of their “principles.” At times, principles can deliver a return on investment by sending a message to competitors or for company morale. However, a business owner needs to be realistic about what he or she can afford to pursue. At the outset of any business breakup, have an honest conversation with your client about what their motives and objectives are. Will their “win” be worth it if it costs X? Do they have business plans that will be difficult to get financing for if there is a contingent liability on the balance sheet for a shareholder buyout? These objectives may change as the dispute progresses, so keep checking in so you and your client can stay accountable to those objectives and expectations.

Keep operations going. Particularly in small companies where only a few people are response for the management of a business, a contentious breakup can bring operations to a grinding halt. The most basic operational and financial decisions can be disputed, preventing anything from moving forward. If it is clear which partner is departing, then he should be immediately removed from management and banking authority. When the partners are fighting for control, it is usually a race to the courthouse. Litigation may seem counterintuitive to keeping operations going, but it is often the best way a partner can enforce the status quo or a change in management. Consider available claims such as a breach of fiduciary duty, breach of contract, judicial dissolution, judicial removal of a director, or a claim for accounting. Bringing derivative claims on behalf of the company can also help a partner take control of the narrative.

rust_luJulia Rust,
is a partner at Pierce McCoy, a boutique corporate firm in Norfolk. She specializes in complex corporate litigation and enjoys helping clients find creative solutions to complicated issues. She handles a range of matters including contract disputes, shareholder buyouts and business breakups, shareholder oppression, and noncompete disputes. Julia is also passionate about community engagement. From 2015-2018, she launched and led the Hampton Roads Chamber’s young professionals program, tHRive, which now boasts more than 2,000 members. She currently serves on the Chamber’s Regional Board of Directors and is actively engaged in her local March of Dimes chapter. Julia is a graduate of LEAD Hampton Roads (2018) and was named a “Millennial on the Move” by CoVa Biz Magazine (2016). Julia graduated from Liberty University School of Law in 2014, cum laude, where she was chairwoman of the Moot Court Board. She has lived in Hampton with her husband, Steve, since 2014.