You are out with your friend or at a family gathering talking with a friend or family member about how each despises their respective employment and the ball starts rolling. “I have a great idea for a business” she says. You have been unhappy with your current situation, you want to work for yourself, and frankly it’s a great idea for a business. Going into business with a friend or family member can be enjoyable and successful. However, there are many issues when operating a business that might arise between the two of you that if not addressed at the outset can destroy the business and the relationship. Here are two major issues that the majority of business partners do not adequately address before starting a business.
Capitalization (Re-Capitalization) Agreements
Many small business ventures are initially funded with capital contributed by the business partners. Once the business is off and running there often is almost always a need for additional capital to provided for continued success. Funding can be available by taking out a small business loan which the business (and often times the owners too) is obligated to repay. However, funding can also be accomplished by owners providing additional capital to the business. This can be extremely problematic as with most business entities ownership is based pro rata on capital contributed by stakeholders. If your aunt, for example, contributes additional capital this can change the control and ownership interest in the business giving her more financial and governing rights over you. A Capitalization Agreement provides for what happens if one stakeholder does not put in his or her share of such necessary additional capital as may be agreed upon or if (as is often the case) one stakeholder loans proportionally more money to the business that does another holder of interest in the business.
Think of a business relationship like a marriage. At some point it is going to end. Business partners retire, move, become disabled, and die. A well-drafted Buy-Sell Agreement provides for the smooth transition of ownership succession for the business. A typical Buy-Sell Agreement works in three stages: 1) It specifies trigger mechanisms which give the business or some stakeholder the right (and perhaps the obligation) to buy out the interest of another stakeholder. Common triggering events include an offer to purchase business interest, dissolution of marriage, insolvency, retirement, death, dismissal of owner from employment as an officer, or a deadlock between stakeholders. 2) It provides a price or method for determining the valuation at which stock or membership units may be purchased. 3) It specifies the terms applicable to such purchase and perhaps its funding source such as disability or life insurance.
As a wise business lawyer once said “The existence of clear code of rules for corporate governance and ownership succession cuts way down on the possibility of a knife fight.”