Going into Business Together: Don’t Rely on a Handshake!

Great – you have found people who share your vision to own and grow a business. But don’t forget that going into business with other people requires you to think ahead and be clear about the relationship. This is your livelihood and future. Do not think for a minute that conflicts can be resolved as you go along. Even the best of friends can end up in serious conflict over issues that might seem minor.

While you may be tempted to save the money that an attorney might charge to document your agreement, think about the thousands of dollars you may have to pay to litigate a conflict or the money you might lose because such a conflict keeps you from operating a profitable business.

Regardless of the legal entity you may choose for your business, think about every issue that might be relevant for your particular situation, and have your attorney draft the appropriate legal papers. Naturally, you cannot foresee every possible disagreement that might arise in the future. Beware of business partners who need to agree on every minute detail of the business-to-be. (That could be a hint that going into business with that particular person might not work out for you in the long term.)

Following are some of the basic issues you need to agree on with your fellow business partners.

1.  Ownership of the Business

Who owns how much of the business? To answer this question, you need
to look at each person’s contribution to the business. What do they
bring – or promise to bring – to the table? Possible contributions are
cash, services (“sweat equity”), equipment, ideas or technology. If
people contribute things other than cash, you need to agree on the
value of such contributions. If someone promises to provide services to
the business, ask when and for how long that person has to provide such
services. What happens if he or she refuses to provide such services
later?

If valuable ideas or technology are contributed to the business, you
need to agree if all or only part of such rights are being contributed
and if these rights are contributed indefinitely or for only a certain
period of time. If the contribution consists solely of a right to use a
certain technology for a limited amount of time, is such a right
exclusive?

2.  Commitment

Do you require a certain time commitment from the people owning the
business? In other words, should the owners be allowed to exit at a
prescribed time? For example, you could agree to an exit by an owner
after two or three years or to an exit caused by an owner’s disability
or another life-changing event.

If owners exit, are they entitled to sell their ownership interest
in the business to the remaining owners or to the business itself? If
yes, how will the value of this interest be determined at that time?
Newsflash to the parting owner: Don’t expect to get your investment
back. If the business does well, you might get more; if the business
does poorly, you might get nothing.

There is a variety of ways to value a business. The basic options are as follows:

•    Predetermined purchase price
The owners come to an agreement
at the beginning about how much the business or the remaining owners
have to pay to buy the parting owner’s share. While it is difficult to
set a price in advance, it may be easier than agreeing to a price once
someone is ready to leave. You could also agree to adjust that price at
predetermined intervals.

•    Appraisal at the time of sale
A costly option is to hire a professional appraiser who will look at the business and determine its value.

•    Book value of the business at the time of sale
The book
value of a business is the value of the assets of the business minus
its liabilities. This does not take into account the reputation of a
business or its earnings potential. It just looks at what a business
has minus what it owes.

•    Earnings of a Business
The value of a business is based on
its annual earnings or a multiple thereof.  The multiple depends on
many issues, such as the potential for future earnings and in general,
the “good will” of the business.

The next question is: how are the remaining business owners (or the business) going to pay the exiting owner?

The owners could use cash (either a lump sum or installments) to pay
the departing owner. Other options are loans or insurance. The
business, or all of the owners, could take out insurance on each owner.
In case of the death or disability of an owner, the insurance would
kick in and provide the funds to pay the disabled owner or in case of
death of the owner, his or her heirs.

3.  Ownership Transfers

Should the owners be allowed to transfer their ownership in the
business to other persons or entities? Or should any transfer be
prohibited? Short of a complete prohibition on transfers, which is
somewhat inflexible, should there be some sort of transfer restriction?

An example of this is called the “right of first refusal.” Say that
A wants to sell his ownership interest in the business to B, who is an
outsider. A has to disclose B’s offer to the other business owners. The
other business owners have the right to buy A’s ownership interest at
the price that A offered to B.

4.  Forced Buy-Outs

Should the owners have the right to force another owner’s exit when,
for example, an owner becomes disabled, declares bankruptcy, has
committed a felony or loses a professional license required in the
business?

Again, the question arises: what is the price of the ownership
interest under those circumstances, and how are the remaining owners or
the business going to pay the departing owner?

5.  Control and Management of the Business

Who has control of the business generally? Who manages the
day-to-day affairs? Should all owners make major decisions, such as
expenditures over a certain amount, the taking on of debt over a
certain amount or the sale of business assets, anonymously?

6.  Loans

At the beginning of a business’s existence, each of the owners may
loan money to the business to keep it going. What are the limits of
such loans, and how are they going to be paid back? Are cash infusions
considered loans or contributions to the business? Loans create debt
obligations of the business to the lending owner.  Contributions by an
owner increase such owner’s percentage interest in the business.

7.  Competition by Owners

Owners may have interests in other businesses or might decide later
to compete with the business in some way. Should that be prohibited or
allowed?

8.  Distribution of Profits

How and when are the profits of the business distributed? Should
money remain in the business or be paid out immediately to the owners?

9.  Where to Document your Agreement

In the case of a corporation, the owners (shareholders) would most likely put their agreement into a Shareholder Agreement.

In the case of a partnership, the owners (partners) would put their agreement into a Partnership Agreement.

In the case of a limited liability company, the owners (members) would put their agreement into an Operating Agreement.

But wait!

The laws governing the different kinds of business entities may
contain mandatory rules with respect to any of the above issues and may
even prevent some agreements you may have reached with your fellow
owners. Your attorney needs to make sure that you choose the right kind
of business entity for your business and that all of the above issues
are dealt with in accordance with your wishes and the law.

10.  Conclusion

Don’t fret if you have neglected to properly provide for some or all
of the above issues. It is not too late to prepare the appropriate
agreements (or amend existing ones) if you have already started a
business. The time to do it, though, is now, before actual
disagreements arise.

(If you need help on the topic "Going into Business Together: Don’t Rely on a Handshake", call a licensed small business attorney in your area.)

About Imke Ratschko


Imke Ratschko is a New York Attorney helping small businesses, business owners and entrepreneurs with all things "Small Business Law," such as litigation, contracts, business owner disputes, shareholder and operating agreements, sale or purchase of a business, investors, and starting a business. You can reach her at 212.253.1027.

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