I had an all too familiar phone call last night with a potential new client. Three individuals formed a business entity through which they were going to launch a promising new software application. They had done everything right – they engaged an attorney to handle the formation and had divided up operating responsibilities according to each person’s strengths. The idea was relevant, the technology was functionally strong, and the angel investors were interested – all was looking good. Then, two of the founders learned that the third had been behaving improperly and perhaps illegally – they wanted that person out . . . out of everything . . . out of operations, out of any officer position, off the board . . . and, “we want the equity back because this person should not be able to retain ownership after breaching contracts and duties.” All reasonable reactions considering they got into this as a team and expected the team would stick together and succeed intact. But, in the face of this breach, they were being told by their existing attorney that the governance instruments and ownership agreement did not support the outcomes they wanted. How could that be!?

Everything is great in the beginning

Not unlike the courtship phase leading to marriage on the personal side, start-ups usually involve a few friendly founders that have no issues between them and only see the positive of what they are undertaking. There is no sign that any of their interests may come into conflict, that any personal circumstances may change and impact the initiative or that any of them may have a change of heart or become unable meet original expectations. Certainly, no one believes, or wants even to discuss, the “unlikely” possibility that conflicts, self-interests, disloyalties or outside influences may develop and harm the business. For an attorney or other advisor to ask about such things and how they should be handled in the operating or ownership agreements is akin to suggesting a prenuptial agreement right before the wedding. No one wants to talk about that, no one wants to throw that cold water on the party and no one wants to take the time to really consider the dreaded “what if.” So, most start-ups glaze over the organizational documentation – “just make us equal,” “don’t worry about this or that,” “we will be able to figure that out if it comes up.”

Then things change

As we have all heard and said many times, the only certainty is change. People change, their circumstances change, the business or product changes -- goals, desires, outside influencers, financial capabilities, loyalties – they can all change. Hopefully, the changes will happen with transparency, communication and cooperation among the founders; but often, conflict, no matter how subtle, exposes itself. At that point, the phone usually rings at the lawyer’s office – “how do we remove this person,” “how do we take the equity back,” “what rights do we have,” “we have interested investors, but they won’t fund until this conflict is resolved.”

The unfortunate reality

Whether for a corporation, limited liability company or partnership, the operating and ownership agreements are intended to establish expectations, rights and rules among the owners and, in some cases, between the owners and the business entity. For start-ups and entrepreneurs, especially, this process is all too often a formality, the details of which are often overlooked in the early stages when all is rainbows and roses and financial success is a foregone conclusion. Unfortunately, unless the founders were willing to challenge themselves at the outset with some contingency planning, the business is in jeopardy from the outset. By the time the founders are forced to confront the situation, there may not be an easy way to extract a problem owner or recover valuable equity. The consequences range from distraction for having to deal with the situation to disruption or prevention of financing or customer relationships to sink-the-ship costly litigation. Investors are not going to pay for this kind of clean-up and customers are not going to wait.

What should be done

Consult an attorney, listen and heed their advice. There are increasingly more on-line, do-it-yourself options for forming and organizing a business entity. These may be fine simply to form an entity or for a single owner/operator business, but most cannot provide the counsel required to understand and evaluate options for operating and ownership agreements among multiple founders. Consider the following:

1. Does the idea, concept or design really belong to one of the founders? More often than not, the concept or idea comes from one person who pulls in friends or advisors to get the idea off the ground. If so, consideration should be given to whether that person should retain controlling interest with the other founders sharing the remaining interest.

2. Will the business be operated and managed in a corporation-style structure with a board of directors/managers or more like a partnership-style structure where all of the owners are directly involved?

3. Is there one founder that will act as the manager of the business, or will all owners have a material role in operations?

4. How should major decisions be made – majority of owners, majority interest, unanimous or super-majority of either of these?

5. What should happen in the event of death, incapacity, divorce, bad/”for cause” acts, indictment, incarceration or other circumstance that render a founder unable to participate or hold their ownership as originally expected? Are there different outcomes if such inability is involuntary versus a decision by the founder to act against the interests of the entity or other owners? Can a founder be removed, and are there circumstances under which the entity or other owners may force a repurchase of that founder’s interests?

6. How should the entity be taxed, and how will profits and losses be allocated?

7. How will cash distributions or dividends be authorized in general and upon liquidation?

8. What circumstances trigger dissolution of the entity? How should the winding up process work? What happens to the assets in such event, especially intellectual property assets?

A Note about Legal Counsel

Engaging an attorney to guide the founder team through development of operating and ownership documents is highly recommended. However, founders must be clear on who a lawyer represents. Typically, if there is only one attorney, then he or she will likely represent the to-be-formed entity, and not any of the individual founders or owners. In considering the questions above and many others, founders and owners may choose to engage individual counsel to advise on that person’s particular rights and interests, which may not be directly aligned with the entity or other owners, especially as time passes. Do not assume that an attorney is advocating for your personal interests without clarifying that relationship in writing.

For more information on forming and organizing business entities and negotiating and drafting operating and ownership agreements, please visit our Employment, Non-Disclosure & Non-Compete Agreements service page, which is part of our Corporate & Commercial practice.

Klemchuk LLP is an Intellectual Property (IP), Technology, Internet, and Business law firm located in Dallas, TX.  The firm offers comprehensive legal services including litigation and enforcement of all forms of IP as well as registration and licensing of patents, trademarks, trade dress, and copyrights.  The firm also provides a wide range of technology, Internet, e-commerce, and business services including business planning, formation, and financing, mergers and acquisitions, business litigation, data privacy, and domain name dispute resolution.  Additional information about the IP law firm and its IP law attorneys may be found at www.klemchuk.com.

Klemchuk LLP hosts Culture Counts, a blog devoted to the discussion of law firm culture and corporate core values with frequent topics about positive work environment, conscious capitalism, entrepreneurial management, positive workplace culture, workplace productivity, and corporate core values.