Thought Leadership

Avoiding the Accidental Partner

Life insurance is an expense a person incurs to protect loved ones from the inevitable. In a closely held entity there are two important “inevitables” against which the prudent business owners should also consider acquiring inexpensive “insurance.”

Specifically, joint owners should have a candid conversation about life’s “what ifs” while the company is young. If they do not, the owners – or their loved ones who survive them – face a potentially unsavory, as well as emotionally (and perhaps economically draining) cleanup of their failure to plan.

We like to refer to these two potential issues as “the Accidental Partner” and the “Inadvertent Lifetime Employee.” Each situation is one that, with just a little planning ahead is easily and inexpensively avoided. In this installment we will cover the Accidental Partner.

Business Partnership as the “Office Marriage.”

Human nature, however, is such that a bride and groom plan a wedding, honeymoon, and perhaps for the dream home they hope to purchase five years hence. They do not, except in the minority of cases, enter the relationship either contemplating or planning for the potential of an acrimonious divorce, six, sixteen, or twenty-six years hence.

The reality is that over half of new businesses fail within the first five years, and two thirds of them within the first ten. Thus, many business “marriages” end without any meaningful assets to divide.

Those business marriages that last – whether their legal form is a partnership, corporation, limited liability company (“LLC”) or other legal entity – will eventually go through some form of counseling and possibly a breakup. As Apple recently discovered, a business is a perpetual entity. Its owners are mortal, so the entity “lives on” after the death of an owner.

The Accidental Partner.

Consider a situation where owners “click” with each other in the work force. The commercial magic they make is a function of many things including that occasionally the two partners likely function as “work spouses.”

This is well and good in the office. It is perhaps more problematic, however, when inevitable life events – death, disability, divorce, etc. – alter the domestic life of one of the owners.

Consider Alex and Pat. They are childhood classmates from the local parochial school who complement each other well inside the office.

Outside the office, their lives took different paths. Pat’s spouse was of a deep religious conviction and drew Pat toward making faith a key component of Pat’s non-working hours.

In contrast, Alex’s spouse demonstrated a greater affinity for altar wine, and Alex’s noncommercial pursuits are more likely to involve hymns in bars than veneration in a house of worship!

While Alex and Pat are able to compartmentalize their personal and commercial lives, neither spouse has the tolerance or lifetime of shared experiences to do the same. What each spouse has, however, is a claim to – depending on the circumstances – some or all Alex or Pat’s share of the business.

This is not a recipe for a successful “second business marriage”!

The inevitable happens. Alex gets divorced or dies. When this occurs, Alex’s spouse is, by default, likely in line to receive ownership of half (divorce) or all (death) of Alex’s interest in the company.

When that occurs, Pat is now saddled with a joint owner who may consider Pat’s approach to business and personal life to be judgmental, or immature, or otherwise lacking in some respect.

Perhaps worse yet, in the event of a divorce, particularly an acrimonious one, Alex’s spouse might attempt to leverage the new found ownership interest into an active role in management of the company. This extra voice at the table, of course, holds the potential for destroying the chemistry that made Alex and Pat a successful management team in the first place. Alex would be constantly battling the former spouse for control, and the company could be potentially thrown into a deadlock or some other unattainable situation.

Another scenario could involve Alex’s spouse wanting to “cash out.” This may be something that is difficult, if not impossible, for the business to accommodate on the terms or payment schedule of the divorcing spouse. Accordingly, having appropriate advance planning permits Alex and Pat to avoid life’s inevitabilities from saddling either (or both) with an accidental partner.

How to Plan Ahead.

Fortunately, Minnesota law permits agreements between the shareholders of a corporation or between the owners of a limited liability company (i.e., members). The purpose of these contracts with each other is to help them avoid the expense, distraction and uncertainty of waking up one day with an accidental partner. These agreements are known as a shareholder control agreement for corporations and member control agreements for LLCs.

These agreements which are driven off of fairly standard forms then tailored to meet each individual ownership groups received needs and concerns, contain clauses that manage expectation (and treat the accidental partner fairly from an economic perspective) at the outset. In the event of either death or divorce, Pat or Alex’s spouse will receive fair value (again, a half or whole interest, depending on whether a divorce or death) for their ownership interest in the business, and the surviving partner will not be saddled with additional cooks in the company kitchen.

For information regarding options for safeguarding your closely held business, please contact Hellmuth & Johnson, PLLC business department chair, Joe Beckman.