Legalese: In Business Divorces, Breaking Up Is Hard to Do

This story originally appeared in the September 2017 issue of AVN magazine. Click here to see the digital edition. Even if you’ve done neither, you should be pretty aware of how easy it is to get married and how difficult it is to get divorced. Well, there’s a strong correlation between the ease of matrimonial marriage and the difficulty of matrimonial divorce and the ease of a business “marriage” and the misery of a business “divorce.” So those who should read this are people thinking about “partnering up” with someone in a business venture. If you already have done so, it is too late to accomplish some of what is discussed here. But this will provide some insight to someone who wants out of a partnership. Start with the fundamentals: In the real world, a business “partnership” means two or more people who are shareholders in a corporation or members of a limited liability company. Anyone who operates a business as a general partnership of individuals either is a masochist or had some really bad business advice (like from one of these legal-form outfits that, in a very straightforward way, promise to give no legal advice). One exception to that is where the partnership is between or among corporations or limited liability companies, where there remains the corporate-shield protection from liability. Here’s the problem with general partnerships: Each partner is liable to all of the partnership’s creditors for all of the debts. That is, a creditor who obtains a judgment against a partnership can collect it from any of the partners. Pretty scary! Corporations and LLCs, as you probably know, have the advantage of protection from that. If a creditor obtains a judgment against a corporation or LLC, it can only be collected from the assets of that entity. The owners are off the hook. A notable exception is that the owners can be held liable for torts that they are involved in committing. So, for example (a real-life story), if there are two shareholders in a corporation and one of the shareholders orchestrates a copyright infringement scheme unbeknown to the other, the offending shareholder can be held liable as can the corporation; but the unwitting shareholder is off the hook (although good luck establishing ignorance). Creating a corporation or LLC is easy. In some states, such as Nevada, the whole thing is computerized so that an attorney can, for example, create an LLC in part of an afternoon; and that filing usually identifies the members. So you’re off and running. Just like one of those drive-through wedding chapels on the Las Vegas Strip! Business divorces can be simple. If the business is really laying an egg, the owners can simply bankrupt the corporation or LLC; and that puts an end to it—unless! That is, unless the operators failed to follow required corporate formalities, by for example mixing corporate assets, liabilities, purchases and sales with personal ones, failing to keep corporate minutes, failing to keep separate corporate bank accounts and credit cards, etc., and, especially, failing to keep up with annual fees, state taxes (especially in California) and annual required filings. That kind of behavior can result in a finding of alter ego—piercing the corporate veil. If that happens, the corporation is treated as a general partnership. See above! So what happens if the business prospers and a problem develops? Lots of things can happen. And let’s talk about a business with two “partners” for simplicity sake; the same problems can crop up where there are more than two “partners” except that the complexity increases exponentially with additional “partners.” (“Partners” is in quotation marks here because, as noted, generally it involves shareholders of a corporation or members of an LLC.) All kinds of things can happen. Without exception, every partner in every partnership thinks that the other partner(s) aren’t carrying enough weight; and that has caused the demise of many a partnership. (Find a partner who says that the other partner(s) work(s) harder than he/she does—no such thing exists.) Partners die. Partners get divorced (matrimonially, that is), which invariably screws up their lives, at least temporarily. Partners become disabled. Partners file bankruptcy. It goes on and on. One partner could die. (People all eventually do that, you know.) If your 50/50 partner dies, then you can find yourself in a partnership with your deceased partner’s spouse, siblings or children, which is not what you bargained for when you created the relationship. Most importantly, it is unlikely that any of those people have the expertise that your partner had in terms of operating whatever kind of business it is and managing a business in general. Worse, if your partner’s heirs are multiple, such as his or her children, invariably they will fight with each other because they have different objectives and stations in life. Kind of like Congress! You try to keep the business alive while they fight with each other about what to do with the business. The solution to that dilemma, and the solution to most of the other problems that can arise, comes from the documentation created at the time of creating the entity, the so-called “subscription agreement” and the bylaws (for a corporation) or operating agreement (for an LLC). Such documentation should allow for what happens, among other things, when one of the partners dies. The easiest provision is to include a restriction on the alienation of shares so that, if your partner dies, you have the first right to buy out the stock from his or her estate. That may sound easy, but what if you don’t have enough money? Example (another true story): One of the partners in a thriving business dies. The documentation has a first-refusal right for the surviving partner. However, the business is so successful that there is no way the surviving partner can afford to buy out the deceased partner’s heirs. The solution to that is commonly called a “buy-sell agreement,” and here’s how it works: Suppose partners A and B each own 50 percent of a business. What they do is agree on the value of that business, which itself is a difficult proposition and well beyond the scope of this article. (The process considers not only assets and liabilities, but also what is called “the value of a going concern.”) The partners then make an agreement that if one of them dies, the surviving partner will buy the deceased partner’s interest in the business for half of the agreed-upon value. How can he/she pay for it? The partners each buy life insurance on each other in the amount of half the business, with an agreement that the proceeds will be used to buy out the deceased partner’s share. That way, the heirs—who have no interest in inheriting a chunk of a business that they had nothing to do with—get what they want, which is money; and the surviving partner gets what he/she wants, which is total ownership of the business without interference from heirs. There are other things that can be done to avoid problems. The paperwork should include mediation and arbitration provisions so as to streamline disputes and keep them confidential. Know this: Business divorces are a mess—always. If they go to court rather than arbitration, then there is the problem of all of the company’s information going public. Do you really want the world knowing your customer lists and pricing? There are ways to protect that in litigation; but it is expensive, difficult and not always successful. Sometimes a partner will just come in one morning and say, “I’m leaving. The business is all yours.” Well, that solves the problem of fighting over the spoils. But leaving for what? Unless the partner is retiring, it’s probably to start a competing venture or work for a competitor. That brings about significant problems with trade secrets, which will be the topic of next month’s column. The moral of this story is this: Having a partner is not always the best idea. Many circumstances arise where two potential “partners” get together: a money person and an operational person. The “money person” means just as it sounds; the “operational person” is the one who knows the technical parts of the proposed business. Here’s an important message to the “money person”: Hire the operational person as an employee on a “percentage of profit” basis, rather than making a partnership, which is the lesson from the above. Now, be careful about calculating percentage of profit. Many lawsuits arise over that calculation. So, the deal needs to be percentage of revenue minus specific things (rent, phone, salaries, etc.). Expenses can add up with things like cars and customer dinners, which cause fights. Ask an attorney who knows how to do this stuff. Clyde DeWitt is a Las Vegas and Los Angeles attorney, whose practice has been focused on adult entertainment since 1980. He can be reached at [email protected] More information can be found at ClydeDeWitt.com. This column is not a substitute for personal legal advice. Rather, it is to alert readers to legal issues warranting advice from your personal attorney.