The following article originally appeared in the December 2009 edition of The Myers Report newsletter published by the firm.

 

You’ve Got the Power . . . Use It!

By Jane M. Myers, Esq.

It happens all the time.

A group of friends come up with an exciting business idea.  Everybody’s pumped and working hard. Everybody’s having fun.

Business love is crackling in the air!!!

Retirement to a relaxing, sun-soaked oasis is just within reach.  This will be the next “Big Idea” …no doubt about it. And the very best part…everybody’s got each other’s back – everybody trusts each other!

The friends enthusiastically shake hands in agreement – they’re all equal partners. They know the Big Idea is a winner but it will take a lot of work to succeed and they’re ready.

And so somebody puts up a lot of cash and then somebody else quits their “day job” so they can really give the Big Idea 100% full time and attention and somebody else figures out a way to find an “office” to incubate the Big Idea. One of the friends volunteers to take on the day to day management of the business of developing the Big Idea.  Then one day, the “manager”  realizes that she’s got other things going on in her life that make it a bad idea if her name is connected to the Big Idea; so instead she has her boyfriend act in her place.  But that’s OK because everyone knows that she’s really the manager of the Big Idea even though her boyfriend has control of the checkbook and is making decisions.

A short time later, one of the friends says his day job has been tugging on his time and attention and, sorry, but he has to spend less time working on the Big Idea.  Pretty soon someone else starts to get a little annoyed because while her day job is tugging on her too, she still manages to give 100% to the Big Idea.

Before long, the Big Idea needs more money to keep going and one of the friends writes a hefty check but he’s a bit uneasy because it’s the third time he’s been asked to do it and no one else has put up any cash.  And what about that other friend who hasn’t put up any money and barely spends any time at all at Big Idea’s offices but sure has a lot to say about what everyone else should be doing?  One of the friends has been permanently transferred to California for business and has “sold” his interest in the Big Idea to his mother . . . and she just adores spending her time at Big Idea’s offices.

Soon, everybody’s feeling on edge and unsure if they’ll ever recoup their investment let alone get a piece of that retirement gold ring that seemed just within easy reach.

Several of the friends aren’t speaking to each other anymore. Big Idea debts are piling up and up. The friends call their accountant. They call their lawyer.

Where did the love go?

What could the friends have done differently?

• The first thing the friends should have done is to form an entity (either a corporation or a limited liability company – an LLC).  The “entity would develop the Big Idea and the friends would have an ownership interest in the entity.

• The second thing the friends should have done is to enter into a written agreement (a shareholders’ agreement if the friends formed a corporation or an operating agreement if they formed an LLC) as soon as the entity was formed. The agreement is somewhat analogous to a pre-nuptial agreement in a marriage. At the beginning of a business relationship it might seem cold and negative if the partners insist on an agreement that addresses what happens if the relationship fails. But having that agreement in place is prudent – failure to insist on it is an open invitation for bitter disagreement between partners who may assume that their plans and goals are the same, but haven’t fully talked things out.  It comes down to managing everyone’s expectations.

• To avoid more upheaval after the business love is gone, the agreement must, at a minimum, contain the following:

1. A description of each partner’s scope of job responsibilities and the services they’ll provide to develop the Big Idea – maybe someone puts up cash and someone else works 70 hours per week – that’s fine if the parties agree in advance.

2. Restrictions on the ability to transfer an interest in the entity – whether the transfer occurs when the partner is alive, dead or permanently disabled. That way, you won’t wind up in business with your friend’s mother or your ex-spouse; the remaining partners or the entity should have the right of first refusal to acquire that departing partner’s interest.

3. A method to value the company – that way you’ll know what a partner’s interest is worth – and payment terms for buying out a partner’s interest.

4. Restrictive covenants – especially for a company that is developing a Big Idea – you don’t want the departing partner to leave and develop the Big Idea by setting up an office next door!

There shouldn’t be any concern about how it might look if you raise the subject of forming an entity and entering into a written agreement to cover how the entity will operate.   The bigger cause for concern should be a potential business partner who balks at your request to discuss what happens if the road to the Big Idea hits a pothole, or better yet, leads to success beyond everyone’s expectations.

 

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Please note that this article is intended only as a general discussion of issues pertaining to the formation of a business and that it should not be taken as creating an attorney-client relationship or as legal advice with respect to any particular person, business or situation.  Circumstances and the applicable legal principles vary and you should consult with an attorney and/or other professionals regarding the facts of your particular situation.