California Business Divorce: "Top 3" Biggest Mistakes Owners Make When Starting a New Business

Stradling Yocca Carlson & Rauth
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Stradling Yocca Carlson & Rauth

Many clients come to us seeking a business divorce without any written agreement setting forth clear, viable rules for dissolution… and they are genuinely surprised to learn about the statistics associated with their plight.

There are many sources regarding business failure rates, however, generally speaking:

  • 20% of businesses fail in their first year
  • 30% of business fail in their second year
  • 50% of businesses fail after five years in business
  • 70% of business owners fail in their 10th year in business

Set forth are our “Top 3” mistakes made by business owners now involved in protracted litigation regarding their business divorce.

  • Don’t assume that you will never get a business divorce. In fact, business divorces happen all the time. Assume, going into the business, that there is going to be a divorce and prepare yourself and your business for that possibility, as there are ways to ensure a potential business divorce happens more quickly, easily, and with less expense.
  • Get your business agreement in writing. You would not believe how many very smart and accomplished entrepreneurs and business owners don’t properly memorialize their business agreements. In addition, we also see business agreements that are written by laymen (not attorneys who specialize in such agreements) or rely upon “templates” from the internet or another source that may or may not apply or properly describe the specific components of what is needed for the business agreement going forward.
  • Retain competent legal counsel. Forming an entity can be complex. Identify the type of entity, the owners and their exact stake in the company. There are many tactical considerations when forming a new business. We have observed, after many years of business divorce litigation, that entrepreneurs who did not seek quality counsel at the onset of the business tend to give away too much equity in the company. Also, legal counsel can advise and guide you through future grants or the vesting of shares, as verbal communications don’t always hold up in court.

We realize these “Top 3” mistakes seem obvious. However, it happens all the time.

In addition to the above, it is critical that entrepreneurs, usually excited to embark on their new adventure, take the time to really understand their business agreements (your lawyer can help you understand the fine print). For example, make sure your business contract includes provisions and protocol in the event of a business divorce. Failure to include a buy-sell agreement for the company could very likely end in expensive litigation and a dissolution of the entire company.

Also, consider different scenarios in the event you or your partner want to start the same business on your own. How will this play out? Are you allowed to take proprietary information, existing staff, and the like. All of this can and should be addressed by your lawyer in your initial business agreement.

What if you want a business divorce and each partner has the same stake in the company and you can’t agree on what to do. What if an indemnity clause kicks in that says the company will cover litigation involving the business, which was originally set up to protect the owners from liability and now results in a tangled mess where the  company could pay for the partner’s litigation against you, and vice versa. This is a potential scenario that could be easily addressed at the onset of the business, i.e., the terms of buy/sell, disagreement and gridlock among partners/owners, and a possible triggering of dissolution.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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