Going into a business endeavour as "equal partners" can give a false sense of compromise and togetherness if that arrangement is not implemented with serious consideration how equal ownership can lead to deadlock in decision making and how to deal with it.
It is not uncommon, almost typical, for two entrepreneurs to seek legal advice at the start of a new proposed business undertaking as equal “partners”. While usually the intent here is equal shareholders and not actual partners, in the legal sense, the same underlying issue of concern is often raised by legal counsel – what happens if two equal partners disagree on an issue important to the undertaking, often referred to as “deadlock”.
Business associates, friends, family and even a husband and wife can fall prey to the sense of equity and fairness created by the proposition of an equal partnership. However as in life so in business – time changes everything. Changes in commitment, social relationships, residence and financial resources can change each partner’s perception of the business priorities and/or the other partner. Disagreements, particularly disagreements on matters of significance to a business undertaking (like growth, consolidation, divestiture or financing) can lead to a breakdown in the original relationship and eventually management paralysis, owner conflict and overall demise of the business and its overall value.
In the absence of specific provisions in either a company's constating documents (such as its articles of incorporation or by-laws) or a shareholders’ agreement (always a recommended, see here), the main remedy available to a shareholder would be to seek a court ordered winding-up of the undertaking – seldom a remedy that suits either party in terms of value, but also a remedy that requires considerable time and expense to obtain.
While no one can ever guarantee a perpetually cooperative and profitable business partnership, in the realm of corporate law there are some options to consider to mitigate the possibility, or eventual effects, of a deadlock situation. However to understand the issue in the context of corporate law an understanding of how a company is managed, or more accurately controlled, is necessary. In that respect, entrepreneurs should understand that:
Shareholders own, and ultimately control a company – subject generally to the relevant corporate statute governing the company, their respective voting power, the constating documents of the company and any shareholders’, voting or other agreement they may enter into with other shareholders and/or the company. For the most part, shareholders can act in their own self-interest as long as they otherwise comply with corporate statute and any agreement they have otherwise entered into.
Shareholders elect or appoint, usually annually, directors of a company which are charged with the day-to-day fiduciary obligation of managing the company. It is the directors that generally decide on issues related to the operation of the company and, in that regard, directors are generally to act diligently and in the best interests of the company (which generally includes, primarily albeit not exclusively, the interests of ALL shareholders not one particular constituency of shareholders). This basic premise of corporate law is often where individuals, in their capacities as directors, can find themselves in a conflict between their self-interest and duty.
Directors can appoint, albeit companies usually employ, officers and other senior management in which specific tasks related to the day-to-day management of a company are delegated – at all times under the supervision and eventual discretion of the directors of the company. Offices like those often referred to as the c-suite (CEO, CFO, COO, CTO, etc.) and the more traditional roles of the president, any vice-president and the corporate secretary are traditional titles given these individuals, however not that many corporate statutes – like the British Columbia Business Corporations Act – do not prescribe any particular title for officers and some do not even require any officers be appointed.
So, typically, two persons start a business and each owns 50% of the voting securities of the company. Each, in turn, agrees that each shareholder will be entitled to one nominee to act as director, being the only directors of the company, creating a board of two with each director entitled to one vote. While the directors can appoint officers and if they did the two directors likely appoint themselves in roles that are generally equal and, regardless, subject to the discretion of the directors in any case.
A disagreement arises – for the sake of this article between the CEO and the President regarding the renewal of the commercial lease. No resolution is in sight, and the disagreement is referred to an upcoming formal meeting of the directors – where the same persons as the designated CEO and President are also the only two directors – and therefore the business partners continue their disagreement and declare a deadlock (usually regardless of any claims of duty and best interests of the company). This disagreement and deadlock is then moved on to the shareholders where again it simply re-emerges in another form, unresolved, but this time which each shareholder confident in their own resolve that they are right and that their respective self-interest prevails. If no resolution is accepted either through a negotiated settlement, buy-out or some formal dispute resolution mechanism like mediation or arbitration the only remedy eventually will be a trip to court, a legal bill, and likely the court-ordered winding-up of the company and the dissolution, so to speak, of the business partnership.
That outcome is seldom optimal to one, and often both, business partners. If it moves through the whole legal process – and it may surprise some to learn that it often does – it is at the very least an expensive, time consuming and sometimes unpredictable procedure.
It does not need to be that way. Mechanisms can be incorporated into the constating documents or drafted into agreements like a shareholders’ agreement that make the process, once deadlock occurs, less expensive, more efficient and generally predictable.
These mechanisms often can be categorized in one of two ways:
mechanisms that seek to resolve the deadlock in one direction or the other, but otherwise have the intent of enabling the business to continue; and
mechanisms that accept that the deadlock is irreconcilable and provide a method to either end the business partnership or end the business – or both.
Resolving (or avoiding) Deadlock
Perhaps the first point under this heading is – just don’t do it. While an agreement to proceed as “equal partners” or “50/50” may sound fair and is usually a non-contentious start to a business undertaking; it may not, under some further scrutiny, be fair and may simply be sowing the seeds of a shareholder dispute. Endeavor Law typically counsels real consideration of the interests, effort and risks involved and how those elements may be incorporated into an ownership model. Is the sweat equity and equity necessarily equal? Are there other ways of attending to any risks associated with both? If the founders are all to be involved with the day to day affairs are their responsibilities necessarily equal? Is there effort guaranteed to be equal? Is their commitment to be consistently equal?
In may circumstances, indeed after some uncomfortable discussions, a more sustainable ownership and management arrangement can be determined that is in line with the realities of the anticipated business undertaking and avoids or at least mitigates the possibility of deadlock conflicts.
Albeit not necessarily a common corporate governance practice in smaller companies, boards typically have the ability to appoint a chair and the articles of incorporation or by-laws can provide that chairman with a second and casting vote in a deadlock scenario. This at least avoids deadlock at the board level, which is indeed important, but can of course who is entitled to act as chair and when and where that designation may change (for example, is it permanent based on some assessment as discussed above, or is it alternated yearly). Certainly and advantage is that, with respect to board decisions, there will be a swift and likely predictable resolution of any deadlock. However, this mechanism gives one party an advantage while acting as chair which negates the concept of common control and therefore may not be acceptable to the other business partner.
Somewhat related to the mechanism above, and often a feature in venture capital arrangements, a two-person founder board can be augmented by a third, and presumably independent, third party joining the board. There are several advantages to this mechanism as, similar to the chair’s casting vote, there will be a there will be a swift resolution of any deadlock. Additionally, the intent of a third independent party may facilitate some additional expertise (perhaps an individual with a background different from that of the founders such as accounting, finance, sales or even law) or experience (perhaps an individual with standing in the start-up’s sector, experience building new businesses, expanding internationally or selling for top value) to a start-up’s board. Potential disadvantages include the need for the founders to actually agreement on a suitable third party with appropriate business expertise; difficulty in finding and securing candidates and any expense (such as insurance, indemnification or fees) related to thereto.
Short of a third, independent board member provision can be made for any dispute or deadlock to be referred to an independent third party (such as a mediator, arbitrator or expert in the field) or, if possible, senior management. In the absence of structural or internal mechanisms as discussed above, this is a common alternative usually build into a shareholders’ agreement. It has the advantages of allowing reference usually to third parties with some background to the matters in dispute, typically in a private proceeding, using a process that is normally more efficient than court proceedings. While this mechanism tends to be suitable for legal or technical disputes, it may not generally appropriate for business disputes, as third parties not involved in the business or with a background in the business may not have sufficient knowledge of the business. Other disadvantages include the cost (there is certainly costs involved in retaining third parties to deal with disputes); potential delay and the fact that, in particular, an arbitrator's decision can be binding despite the fact that it is not a desirable result for either founder. Perhaps more significantly, a founder party that finds itself on the wrong side of a third party determination – either on a matter of particular importance to that founder or repeatedly on a number of matters that subsequently lead to a disagreement – may subsequently become uncooperative with the other partner or disillusioned in terms of the whole business undertaking. This is obviously not optimal to any going concern.
Of course, consideration may be given as to whether any of the above need to be triggered immediately. It may be more acceptable to the founder parties to provide for a cooling-off period (for example, having a mechanism to suspend a meeting and re-convene a week or two later before declaring a deadlock) or providing for a prescribed period requiring discussion or negotiation before formalizing a deadlock – after which any of the above scenarios are then implemented. While this provides more opportunity for a suitable business settlement (which is always preferred), such mechanisms are difficult to implement on the fly and, even more so, in the context of a pre-existing dispute between the two founders.
This article started with an explanation of the all too often default resolution of deadlock by way of a court ordered winding-up. So, to be complete, the provisions in most corporate statutes to have shareholders seek remedies in the applicable Court and for that Court to have, as one possible remedy, the ability require a court ordered winding-up is the ultimate divorce for business partners in a deadlock situation.
However each of the following mechanisms offer alternatives, with consequential advantages and disadvantages, to a court ordered winding-up. Interestingly, each are available remedies for a Court under the Business Corporations Act (British Columbia), however each may be more effectively and predictably implemented through the use of a shareholders’ agreement or similar document.
The first mechanism is often referred to as a “shot gun”, “Russian roulette” or "shoot-out" procedure. Under this mechanism typically one party makes an offer to sell or an offer to buy all of the shares of the other party for a particular price, such other party then having either the ability to accept the offer or counter-offer to sell or buy, as applicable, at the same price. Consider in the context of a potential court ordered remedy in Kinzie v. The Dells Holdings Ltd., 2010 BCSC 1360, the concept is premised upon any party making a fair offer to the other party since to do otherwise only could subject the offering party to the same terms. If this is true one advantage is that the extra administration and expense of a third party valuation is avoided since it is presumed that the original offering party will put forward a fair price. It also provides an exit by one party while assuming the continuance of the business venture by the other party. However, the disadvantages need to be considered and, in particular, the possibility of manipulation in circumstances where one party has more financial resources than the other party and, therefore, could invoke the procedure in the knowledge that the other party could not fund the counter-offer. This mechanism also has an element of risk since any party triggering the process has no control over whether it will end up being a buyer or a seller.
In a similar process referred to as a "fairest sealed bid process" elements of the shot gun mechanism are facilitated by the parties submitting a price which it is prepared to purchase the other party’s interest for to an independent third party. The independent party then decides which of the bids represents the "fairest price" and the party making the fairest bid is then entitled to acquire the other party’s interest for that price. Something similar to this was adopted as a court ordered remedy in Mostyn v. Shmiing, 2011 BCSC 275. While very similar in terms of advantages and possible disadvantages, it does require both parties to step up with offers and to also have a justified mechanism for determining a fair price. However, it does very much favour the party with deeper pockets –if that is an issue.
A related mechanism to both of the above is the compulsory buyout. This mechanism was considered in Caribou Western Lumber Ltd. v. Mochizuki, 2000 BCSC 1537, albeit the process is perhaps better incorporated into an agreement to avoid the courts discretion to “strike a fair balance”. Generally a compulsory buyout mechanism allows for one party to buy out the interest of the other party in accordance with a predetermined price or formula in the event that a deadlock occurs. Generally having most of the advantages of the shot gun mechanism, it also provides a significant degree of predictability and as such avoids most of the risk associated with shot gun mechanism. However, it does require agreement as to which party will buy-out the other and/or agreement on the process and price or formulae to be used.
Any of the divorce measures above may become necessary in order to save the business undertaking at the expense of the business partnership. However these mechanisms are best left as a last resort. The exit of one business partner may, in some circumstances, mean the eventual death of the business undertaking in any case – or at least a severe blow to operations, supply chains, the use of intellectual property or just the benefit of the exiting owner’s efforts. Consideration should, therefore, be given to whether the withdrawal of one or other of the founding parties would lead the business venture collapsing completely, or its value effectively being reduced to nil.
Endeavor Law can assist shareholders who find themselves in or on the cusp of a shareholder dispute and, of course, provides legal advice and services related to business structures, incorporation or any agreements dealing with shareholder relationships. Endeavor Law will always seek to provide competitive pricing for any legal services requested and is pleased to discuss fee arrangements that suit any potential client.
Does not constitute legal or other advice and must not be used as a substitute for legal advice from a qualified legal professional in your jurisdiction who has been fully informed of your specific circumstances. Information may not be up-dated subsequent to its initial publication and may therefore be out of date at the time it is read or viewed. Always consult a qualified legal professional in your jurisdiction.