The Start-up Break-up: What to do when informal business relationships go bad, and it’s time for divorce

Posted by William J. Piercy on

Tim and Hank were college roommates who became business partners. Fantasies of Zuckerberg, Gates, and Silicon Valley kept them awake at night working toward the “next big thing.” Their efforts produced a promising idea. The only one thing missing to bring it to market was money.

In their quest for capital, Tim and Hank met Andrew, who claimed powerful contacts in the funding community. In exchange for facilitating the capital necessary to bring the business concept to market, Andrew requested a one-third ownership stake in the venture. Hank was skeptical, but with little hope of funding from other sources, Tim suggested they give Andrew a chance to make good on his boasts. Tim, Hank and Andrew each contributed $1000 of seed money to get the business concept off the ground, but did not discuss whether these were loans or equity contributions, or whether Andrew was on the same footing in the business as Tim and Hank.

Time passed, but neither Andrew’s contacts nor the funding materialized. Frustrated, Tim suggested they each infuse more of their own money to keep momentum up. While Tim and Hank put in the money, Andrew refused, claiming he would bring big investments soon. At the same time, Andrew became belligerent and difficult to work with. Tim and Hank found that if they were to move forward with any initiative, it was far easier to do so without Andrew’s input or involvement.

Along the way, Tim and Hank formed The Next Big Thing, LLC, but did not create a formal operating agreement or other corporate governance document. Tim and Hank continued investing time, money, and energy into the enterprise while Andrew made more empty promises about funding.

Eventually, Tim and Hank could take no more and asked Andrew to take his $1,000 back and go away. Andrew refused and claimed a one-third interest in The Next Big Thing.

Other than discussing the possibility that they each would own one-third of the company, their conversations were not memorialized in an operating agreement or other corporate governance document. While Tim, Hank, and Andrew each have their opinions about who owns what, the issue is not as clear cut as any of them would like it to be.

Tim and Hank are stuck and don’t know what to do. Working with Andrew is not an option and the idea of sharing a third of the profits from their hard work while he sits on the sidelines is nauseating.

What can Tim and Hank Do to Get Rid of Andrew?

1. Pay Andrew and Call it a Day
The simplest solution would be to buy a release from Andrew. Money talks, and there is some sum that Andrew would accept to release any claims he might have against Tim, Hank, and Next Big Thing. A release will wash everyone’s hands of the conflict and placate any future investor or buyer. But, Andrew may be dreaming of bigger future returns and may not be satisfied with any offer Tim and Hank are able to give.

2. Go to Court
If Tim and Hank are unwilling to concede an ownership interest to Andrew but want a final determination, they can file a lawsuit seeking a declaratory judgment to determine Andrew’s interest, or lack thereof, in Next Big Thing. A court ruling that Andrew has no ownership interest would probably be just as comforting to a potential investor as a release, and it does not require Andrew’s consent. The downside is that litigation is costly, time consuming, and may suck the creative energy out of the endeavor. Also, there is a possibility that it will backfire and the court will find that Andrew is entitled to an ownership interest.

3. The Freeze-Out Merger
Tim and Hank may be able form a new company and contribute their shares in Next Big Thing to the new company in exchange for 100% ownership in the new company. They become the sole owners of the new company, and that company becomes the majority shareholder of Next Big Thing. They then cause Next Big Thing to merge into the new company, with the new company as the surviving corporation. Because the new company now owns a majority of Next Big Thing, Georgia law allows for merger by a majority. The merger can be structured that Andrew, the minority shareholder, receives cash in exchange for his share in Next Big Thing with or without his consent. Because Tim and Hank essentially conceded that Andrew has a minority interest, under Georgia law, Andrew will have the option accept the cash or challenge the merger under the “Dissenter’s Rights Statute” if he believes he has been underpaid. This option would force a clear resolution of the conflict, but may result in expensive litigation.

4. Sell the Assets
Because Tim and Hank are majority shareholders, they can vote for Next Big Thing to sell its assets and distribute the sale proceeds pro rata to Tim, Hank, and Andrew. Then, Tim and Hank, if finances allow, can outbid all other bidders and purchase the assets back from the company, effectively buying Andrew out without his consent.

To do so, however, and to avoid Andrew arguing that the sale was a sham and did not bring fair value, Tim and Hank need to take steps to ensure maximum value. Another downside of selling the assets is that it may not satisfy a future investor and buyer, who will want an ironclad release or court judgment. But, if done with transparency and at face value, Andrew will be hard-pressed to challenge the buy-out in court.

5. Ignore Andrew
Hank and Tim could simply move forward with Next Best Thing with the hope that Andrew forgets them. If the project truly turns out to be the next big thing, Andrew will be licking his chops to get a piece of the pie. At that time, however, Tim and Hank will probably have the assets to fight him off or buy him out.

6. Acknowledge Andrew’s Ownership, but Don’t Make Distributions
Next Big Thing is not required to make distributions to its shareholders even if Tim and Hank concede an ownership interest to Andrew. Instead, Next Big Thing can hire Tim and Hank as employees and pay them reasonable salaries commensurate with the company’s profits. If more profits are generated, they may increase their own salaries. There could be a tipping point, however, where profits are so great that it is no longer reasonable to pay all the profits as salary. There are worse problems to have.

This option will also be problematic when the time comes to sell the company, because Andrew will be entitled to his third of the proceeds.

7. Dissolve the Company
Tim and Hank could vote to dissolve the company and distribute the assets to the shareholders. The challenge of this solution is to find a way to make everyone happy with their share. It may be tempting to give Andrew the assets Tim and Hank do not want and keep the assets they need to form a new business, but this would put Andrew in a good position to challenge the dissolution as a sham.

8. Abandon Ship
Unfortunately, the hassle and headache may make it worthwhile for Tim and Hank to simply walk away from creating the next big thing.

Regardless which path they chose, Tim and Hanks would do well to find themselves good “Business Divorce” attorney to advise and help them implement their chosen strategy.

*Joshua Joel is a law clerk at Berman Fink Van Horn P.C. and a third-year law student at Georgia State University College of Law.