The Russian author Leo Tolstoy famously said in his novel Anna Karenina that “Happy families are all alike; every unhappy family is unhappy in its own way.” While Tolstoy was writing about 19th Century Russia, this quote is equally prescient in the 21st Century about the internal relationships between owners of businesses, whether bound together as a company, partnership or corporation. Our lawyers have handled many business breakups over the years and written much about the legal issues surrounding them. (Click here to see our Business Breakup Practice Team.) This article and the ones to follow, however, focuses not on the legal issues but on the emotional, financial and psychological reasons that can cause friction between co-owners and ultimately drive a business breakup; legally known as a dissolution.
Laying the Foundation: Designing Ownership and Compensation Structures
Businesses are often born out of a desire to either create something new or build a better mousetrap whether through new technology, process or attitude; or through better pricing. Other reasons include the desire of some people to work for themselves, try to make more money or even desperation to find work.
Regardless of the reason, if there is more than one owner of a business, then they have more than just a business to manage. The owners need to handle the delicate nature of managing their relationships with one another. Surprisingly, many people when deciding to form a business together do not focus on the relative strength of their relationships and whether they are compatible as business owners. And they often do not think about, much less discuss or negotiate, the proper allocation of work, capital risk and (if all goes well) reward. Even more rarely do co-owners examine their available legal rights should their internal relationships go sour and a dissolution becomes desirable to some or all of the owners. Yet by becoming owners and possible officers or directors, they may create any number of fiduciary duties between themselves or the company.
There are many reasons why potential business co-owners avoid engaging in these types of conversations. One reason is that everyone has their own blind spots that make them vulnerable to overlooking key issues. For instance, people often assume their co-owners will work approximately the same schedule as they do. Some people will commit to working seven days a week to get the business off the ground, and they will expect their co-owners to do the same. Others, however, may firmly believe that their career five-day-a-week schedules are perfectly appropriate to successfully launch the new business. That effort difference by itself can cause major friction. Those blind spots, thus, lead people to assume facts about their business partners or events that can be painfully inaccurate for all involved.
People also avoid conversations about compensation for the simple fact that just having owner believes that they should receive vis-à-vis their co-owners. There are many reasons why compensation differences might be appropriate, such as differences in skill, time commitment, performance or seniority. But, even if someone believes that unequal compensation is appropriate, presenting those arguments to that person’s co-owners can be an unpleasant task. And it is a task that many people would rather avoid even to their financial detriment.
To avoid this unpleasantness, some business focus on equalizing the system for earning compensation rather than equalize what people earn. Such a system is designed to reward performance. To create an effective system, the owners must agree upon which efforts are compensable and how compensation will be calculated. Designing the compensation system is usually done at the outset of the business. And, while the owners can change it at any time, they often do not. But designing such a system can also be fraught with difficulties because people often overemphasize the value of the areas in which they excel and minimize the other areas.
Like compensation systems, structuring the ownership interests are often cut with the rough edges of a timber saw rather than with a scalpel. Fifty-Fifty and and similar equal split deals are common. This is true even when the owners know that one or more of them will commit more of their time to the enterprise. Again, the difficulty of having the conversation, perceived or actual, can silence owners from “rocking the boat.” And because many owners perceive their relationship to be easy to describe, they often do not seek legal counsel to draft the corporate documents.
Once the internal ownership structure and compensation system are resolved (or resolved enough) owners begin the business itself and the internal process of working together. The business can either succeed, be stuck in neutral or fail. Each outcome can cause friction between business owners, but perhaps paradoxically, some of the bitterest conflicts are born out a business success. We will explore that issue the next article.