Advantages of Detailed Agreements between Owners of a Business: Part I, Risks of Doing Business without an Agreement

It is generally understood, for both large and small enterprises, that it is important to do business under some type of legal entity, typically a corporation or limited liability company (LLC).  This is particularly true when the business is owned and operated with one or more “partners,” in the general sense of that term (there’s also a legal sense that I won’t get into in any detail).  The principal advantage is that the entity can provide its owners with a liability shield from claims by outside parties.  This way, the entrepreneurs can do business without worrying that one unexpected loss or lawsuit from a third party could result in the end of the business, and possibly the loss of their primary homes, retirement savings, or other personal assets.  There are exceptions to this liability shield, of course, but that’s a topic for another day.

The main topic of this article is, instead, that the business entity may not provide any protection inside the liability shield.  That is, the entity generally does not protect individual owners from claims against each other regarding the operation of the business.  These disputes are common and can result in protracted litigation, at the end of which there may be no real winners. 

Fortunately, there is a relatively straightforward and often overlooked means of mitigating that risk: what I will call the intra-owner agreement. 

For the different types of typical business entities, these intra-owner agreements are generally called:

• For Corporations (C- or S-corps, PCs and DPCs, etc.): “Shareholders’ Agreements” or “Buy-Sell Agreements”
• For Limited Liability Companies (LLCs and PLLCs): “Operating Agreements”
• For General/Limited Partnerships: “Partnership Agreements” or “Limited Partnership Agreements”

These are contracts between and among all of the owners and the entity, establishing certain ground rules.  These rules typically cover: who owns what proportion of the business; whether and to what extent the owners must also provide services to and on behalf of the business; owners’ voting rights and the amount of votes needed for certain types of business decisions; what should happen when an owner dies, wants to leave the business, or the other owners want to add or expel another owner (or should they even be able to do that?); and how to terminate the business and wind up its affairs.  Generally speaking, state and federal courts will enforce the terms of intra-owner agreements as written, making them an essential tool for ensuring that the owners’ understandings of their business relationship are reasonably clear, while also deterring questionable legal claims that contradict what’s in the written agreement.

Without such an intra-owner agreement in place, the law provides certain “default rules” on all of these issues (and others).  Many of the default rules may not reflect the owners’ personal understanding of their business relationship, which was built during years and decades of handshake agreements, acquiescence in certain behaviors, and aversion to the potential costs of up-front legal counsel.  In the event of litigation, and with no written intra-owner agreement in sight, courts are supposed to apply the default rules to determine the end results, and those results can be highly unpredictable.  And even if the results are predictable from a legal standpoint, they may still be fundamentally unfair.

For example, say three siblings inherit a restaurant business started by their parents decades ago, and in which they had all grown up working, making their parents proud.  All three siblings initially agreed over dinner one night that they would each take the same regular pay, have the business pay their reasonable expenses and health insurance premiums, and that each would do different work for the business.  After a couple of years, one of the siblings becomes notably less of a contributor to the business efforts, but is still taking the same pay and benefits, as well as running up the corporate credit cards with personal expenses.  In order to keep the peace, the other two siblings allow this behavior to continue for years more. 

Eventually, they decide they’ve had enough, and want the unproductive sibling out.  They tell him that they don’t owe him anything for his ownership interest because, instead, he owes the business a large credit for all the pay, health insurance premiums, and expenses he’s been given over the years.  Seems rational, right?  But under most default rules, the productive siblings would be wrong, and they may have to pay the unproductive sibling a lot of money to surrender his one-third ownership interest in order to avoid expensive litigation (which they might very well lose).  As an aside: maybe the credit card use could be considered a loan that needs to be repaid; but who was keeping track, and does anyone really want to pay for a forensic accounting? 

So, in the end, the productive siblings who already had to pay the unproductive sibling not to work will now have to pay him a lot more to leave the business entirely.  The alternative options are not good: close up and dissolve the business, or hopefully find a buyer at a good price.  Not what Mom and Dad would have wanted to happen.  I would consider this a fundamentally unfair result, and I imagine most other folks would, too.  Unfortunately, it is seen often. 

Now consider an alternative scenario: rather than agree to be bought out, the unproductive sibling sues the other siblings under a number of available legal theories, generally asserting that he is being oppressed and forced out of the business.  This may be due to bad blood, a belief that he can leverage a higher buyout price, or both—the actual merit to his claims may not really matter from a business standpoint.  Nevertheless, he claims that he has suffered hundreds of thousands of dollars in damages at the hands of his diabolical siblings, who he also claims have been improperly bleeding the business dry for their own personal gain, as well as shortchanging employees their wages and overtime.  Can the business pay for the productive siblings’ attorney(s) and other legal defense costs? 

As an up-front matter, the answer is generally no: the productive siblings will have to pay out of their own, post-tax funds.  And while they may have a right to be reimbursed those expenses by the business if they win, there is no guarantee that the court would grant them such an award, or that their sibling would pay it.  This is the sort of lose-even-if-you-win scenario I was referring to above.  On the other hand, if they lose, then a judgment would be entered against them personally, putting their personal assets at risk, with no liability shield.  Moreover, it is likely to take years of litigation and appeals to arrive at final results from the court, and by that point, the legal, emotional, and time expenditures are likely to outweigh the benefits of any favorable ruling. 

So, the clearly better approach, both from an advisory and litigation perspective, is to negotiate and execute a thorough and well-fitting intra-owner agreement early in the relationship, and amend it as the business develops.  While intra-owner disputes may not always be avoidable, a solid intra-owner agreement will go a long way to both avoiding a dispute in the first place, as well as making the results of litigation more predictable if an agreed resolution is not possible. 

Looking past these cautionary tales, in Part II, I will discuss some of the positive reasons why all business owners should get an intra-owner agreement.  This is because not only do these agreements potentially avoid trouble, they can also grant entrepreneurs many desirable and legally-enforceable rights that don’t exist under the default rules. 

Michael R. Frascarelli, who may be reached at mfrascarelli@cmrlaw.com, is an attorney and counselor at law focusing his practice on general commercial contracts and litigation, construction contracts and litigation, business law and ownership disputes, intellectual property, insurance coverage, bankruptcy, environmental law, land use, employment, health care, appeals, and other matters before state and federal courts.  He also represents clients in alternative dispute resolution proceedings (mediation and arbitration) and in pre-litigation assessments and negotiations.