Definition

For many entrepreneurs, the term “business divorce” is the most frightening prospect. The term refers to the legal separation of business partners who cannot continue operating the company together. Unlike family divorce, “business divorce” is primarily focused on the division of assets and liabilities. Depending on the applicable law, governing documents, and the partners’ intent, this separation may result in the entity’s dissolution or survival after a member’s departure.

Reasons for Separation

Business divorces occur in different entity types, including partnerships, limited liability companies (LLCs), and corporations. While the business relationship is the primary focus, the reasons for the partners’ separation can be deeply personal. The reasons may include significant disagreements on major company decisions, financial issues, differing visions, partner misconduct, or personal disputes.

For example, a disagreement over whether to reinvest profits or distribute them, or different views on taking risk can lead to an incompatible outcome. In family businesses, personal animosity between family members can overflow into business matters. Further, one partner may want to explore new markets, while the other may prefer to focus on optimizing and consolidating existing operations. Such disagreements put the company’s growth and success at risk, making a partners’ separation inevitable. Finally, a partner may claim the other partners’ misconduct, alleging waste, mismanagement, or other breach of fiduciary duties.

Legal Framework

The roadmap for a partner’s departure is typically found in the company’s governing documents, such as an operating agreement or shareholders’ agreement, or in applicable statutory rules.

In many instances, the company documents do not allow partners to leave the moment they decide. Moreover, if a written agreement does not exist, the parties are governed by default statutory rules.

Some states provide for special dissolution and separation rules. For example, Delaware law provides distinct separation ways depending on the entity structure. Under 8 Del. C. § 273, a 50/50 stockholder in a corporation may petition for dissolution in the event of a deadlock. However, if ownership is not a 50/50 split, initiating judicial dissolution becomes significantly more difficult. On the contrary, members of a Delaware LLC or a partnership have more flexibility to demand dissolution than stockholders of a corporation. If it’s no longer reasonably practicable to carry on the business in compliance with the operating agreement, the court can dissolve the LLC.

Negotiation and Leverage

The departure of partners can be negotiated or decided through the court. Litigation should be a last resort, however. A “negotiated way out” is usually less expensive than a court fight. An experienced attorney can use specific legal mechanisms to leverage a settlement or a fair buyout. For instance, an attorney may help a partner exercise their right to inspect books and records and claim mismanagement, in an effort to force an adequate buyout demand. With or without leverage, negotiating a satisfactory solution is faster and cheaper for partners than litigation.

Additionally, as an alternative to a missing exit clause in the LLC operating agreement, a well-drafted separation agreement can preserve the remaining business and protect the departing partner’s interests.

Planning for Departure

In preparation for departure, the first step is to consult an attorney to understand the consequences and options. Taking unilateral action, such as starting a competing business or freezing accounts, can constitute a breach of fiduciary duty and expose a partner to significant liability.

Before taking any action, a comprehensive assessment of the following matters can build a safe pathway for a departing partner: 1) determining what assets and liabilities belong to the company versus individual partners; 2) estimating the company’s value; 3) clarifying the ownership of intellectual property: trademarks, patents, and trade secrets; 4) evaluating potential fiduciary claims: misappropriation of funds, corporate opportunities, shareholder oppression, etc.

For example, if liabilities outweigh the company’s value, the cost of dispute resolution, whether in court or through alternative procedures, may exceed the potential recovery.

The Value of Preventative Measures

The most effective way to manage a “business divorce” is to prevent the conflict before it starts. The more discussion takes place before the business launches, the easier and cheaper the departure is. Negotiating explicit buyout and exit provisions in company documents at the outset of the venture ensures a predictable departure. If the original documents are silent and negotiation has not yielded the desired results, mediation or arbitration is often a more expedient alternative to traditional litigation.