Honor Among Thieves

The idea of the proverb dates back at least to Cicero, an orator, lawyer (go figure), and politician in ancient Rome. Even in Cervantes’ Don Quixote, published in 1612, the idea is noted as having a long history:

“The old proverb still holds good, thieves are never rogues amongst themselves.”

What does that have to do with forming an agreement among business owners? While you can “hope” that your fellow business owners are as honorable as thieves… it is absolutely best practice to write it down! Forming a contract amongst the business owners is one of the first, and potentially on of the most important, items that a new business should take care of.

A contract, or agreement, amongst business owners has various names depending on your organizational characteristics:

  • Corporation (C & S) = Shareholders’ Agreement (Corps also have mandatory bylaws, which outline the governing of the company’s operations – there may be information that becomes duplicative or contradictory between your bylaws and Shareholders’ Agreement so be diligent.)
  • Limited Liability Company = Operating Agreement
  • Partnership = Partnership Agreement (you saw that one coming, didn’t you?)

NOTE: As we look to address some of the critical elements of these agreements, we will do so by addressing them as simply the “agreement” and referring to “owners”, words such as “shares” and “equity” should be used interchangeably – if a particular element isn’t applicable, we’ll try and point that out.

What is the overriding purpose of an agreement amongst business owners? It is intended to make sure that the individual owners are treated fairly and that their rights are protected. Further, the agreements tend to describe how the company should be operated and outlines the owner’s rights and obligations. Additionally, it allows the initial owners, the founders, to make decisions about what outside parties may become future owners. So, what items should you address – a bunch – here are some highlights.

NOTE: This is not suitable as a replacement for proper legal and professional guidance, it is just a starting point to help you gather your thoughts. We think a best practice is for the owners to figure out what they think they want in broad strokes and then bring in the big guns to tighten things up and add the legalese. Who doesn’t like a page full of “whereas”?!

I suggest taking our first cues from Partnerships – amongst Partners, as with thieves, there are certain inherent fiduciary duties (we won’t get into all the legal ramifications of that, just the spirt of it). These are the Duty of: 1/ Good Faith & Fair Dealing (sometimes referred to as Goodwill); 2/ Loyalty; 3/ Care; and 4/ Disclosure.

  1. Good Faith & Fair Dealing – acting with honesty, faith and fairness to each other. This obligation underlies the performance of all the other fiduciary duties. It starts at formation and continues through the ultimate sale or dissolution of the company.
  2. Loyalty – placing the success and interests of the company above their own personal or business interests; and avoiding conflicts of interest.
  3. Care – acting in a reasonable and prudent manner when carrying out the business of the company.
  4. Disclosure – Partners should make full disclosures of known and relevant potential risks and benefits so that the business may make impactful informed decisions. Full candor amongst each other is a must.

If all business dealings were carried out with these items as the backbone of our personal and business operating systems then there would no further need to take this any further… alas, we will now enter the realm of business contract law.

Generally speaking, the following elements are presented in the bylaws or other organizational/ formation paperwork – but can also (or for the first time) be covered in the Owners’ Agreement:

Company Management and Operation

  • Board of Directors – how many, how appointed, powers, etc.
    •  LLCs/Partnerships may have a Board of Advisors instead – although not required
  • Appointment and responsibilities of the Officers/ Managers/ General and Limited Partners
  • Declaring a dividend/distribution/draw
  • Dissolving the company
  • Entering bankruptcy
  • Changing the business of the company

Information and Meetings – the when, where and how. Standard and special meetings. Procedures for calling, quorum, et cetera.

Amendment and Termination – how this can happen with items within the bylaws and/or Owners’ Agreement. The process, votes needed, et cetera.

Governing Law – locale, county, state, et cetera.

Now – some of the more specific elements that you may want to consider within your Owners’ Agreement:

Share/Equity Vesting Clause – Share/Equity Vesting basically means that founders do not own the equity until some conditions are fulfilled. This benefits the company in multiple ways, including encouraging retention and postponing the pay out of cash. The conditions and details of how equity is vested are known as the Terms of Vesting, which should be stated in the Owners’ Agreement to avoid disputes.

Pre-emptive Rights and Rights of First Refusal– These clauses serve to protect existing owners from the involuntary dilution of their stake in the company. Any new issuance of equity (pre-emptive right) or outgoing owner’s equity (right of first refusal) must first be offered to existing owners before they can be sold to a third party. Such rights are usually on pro- rata basis, although in some cases, the parties may agree to a “super pre-emption” which means some shareholders may be entitled to invest more than pro-rata.

Special Rights to Appoint Directors – This clause is introduced to secure the interest of minority owners. In general, minority owners cannot block the passing of ordinary resolutions, such as the appointment and removal of board directors/advisors. In other words, a minority owner can have 49% of equity but still have no power to influence the composition of the board. To mitigate such rigidity, the owners’ agreement can provide for a clause that enables a minority owner, with a minimum percentage of share, to appoint or remove a board member.

Super Majority Clause – equity owners may opt for a supermajority clause, which requires that certain major decisions can only be passed with the consent of more equity owners, say 75%. This prevents minority owners’ voices from being buried and affords them with more bargaining power in the company.

Non-Competition/Non-Solicitation Clause – Non-competition and Non-Solicitation clauses are commonly found in Owners’ Agreements. By clarifying when and how an owner may carry out rival activities during and after his time as an owner of the company, it eliminates any ambiguity that may arise due to the want of explicit restrictions. The rationale behind controlling owners’ external pursuits is that prime knowledge about the company’s intellectual property or management system, which are crucial elements to keeping the company’s edge, shall stay confidential notwithstanding the come and go of owners.

Deadlock Resolution Clause – A pre-agreed dispute resolution mechanism is constructive towards overcoming deadlocks in both 50:50 owned companies and companies with disproportionate ownership. When owners with equal standing are unwilling to budge from their stance or when a super-majority or unanimous consent is required but cannot be attained, the company enters a deadlock. This would force an otherwise completely functional business into a standstill if the owners cannot compromise and move forward as one. The Owners’ Agreement should define, ahead of time, what constitutes a deadlock (e.g., the failure to pass a resolution after two or more attempts) and the remedy for such an occurrence.

Actions Involving Shares – restrictions on freedom to dispose/ sell shares; restrictions on issuance of new shares and dilution; inability to pledge as collateral, et cetera.

Conflicts of Interest – the right of a shareholder to have an interest in an outside business may be stated in the agreement (further – outside of the owners’ agreement, board members usually must sign a conflict-of-interest policy statement).

Effect of Noncompliance – if an owner doesn’t comply with the agreement, they may be removed as an owner and any transfer they make would be null and void.

Waiver of Jury Trial/Arbitration – the agreement might include a section stating that the parties agree to waive a jury trial and to settle all disputes with arbitration. The arbitration process should be discussed in detail and may even be its own subsection.

Valuation methodology – there will come a time when an owner wants out, maybe there is an age disparity, somebody lost their fire for the business, whatever… having a framework for establishing a value or range of values will prove to be helpful when that time comes. (This section should definitely be revisited often as the science here constantly evolves).

New Parties – The agreement allows for transfers to other parties, but they must first acknowledge the terms of the agreement. After signing the statement, the new party is considered an owner for the purpose of the agreement.

Impact/ Last on Departing Parties – just because a certain owner “sold out” doesn’t mean that their duties to the business are concluded. Ensure the lasting impacts are thoroughly considered.

Wow! What just happened? (and this is hardly a conclusive list) I thought going into business with my buddies would be fun – just ask Eduardo Saverin (Mark Zuckerberg’s first “friend”) how fun it can be. Taking this part of formation of a business lightly can cause for outsized headaches and possibly lead the business to ruin.

I know that nobody likes to think about breaking-up when they are starting something, but contracts that outline an appropriate way of handling hard issues, when emotions aren’t high, isn’t the worst idea. Reviewing the wiki list of most expensive divorces –will lead you to two obvious conclusions:

  1.  A good contract can be worth its weight in gold.
  2. Women are smarter than men – there is only one on the list, Madonna, obviously they take contractually protecting their wealth much more seriously.

So, do yourselves a favor, take this aspect of your business formation seriously. Yes, it can be uncomfortable, and it will cost a few bucks, but the health and sustainability your business will gain is priceless. And even go one step further, each year, at your swanky owners’ and board retreat – review your Owners’ Agreement(s), make any necessary changes or updates and sign off again!

Remember, not everyone is as honorable as thieves. Good luck out there.

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Stephan P. McMahon & Company