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Preparing for a Business Divorce: Deadlock and Related Buyout Provisions in LLCs

Added by Hawley Troxell in Articles & Publications, Business Law on May 28, 2014

We have all seen the joy that surrounds a newly married couple as they look at each other with feelings of endearment and believe, at that moment, that nothing could ever come between them or break their union apart. Sadly, most of us have also witnessed the emotional turmoil present when the couple later determines that a divorce and complete separation is necessary. Not that dissimilar to the feelings of our hypothetical happy couple are the feelings two new business owners have as they formalize a new business venture as equal partners. A failure to properly prepare for a complete separation should the need arise is often a trap for the unwary. While neither business owner wants to consider at inception of the venture what may ultimately become necessary, failing to take steps to discuss and document what will take place if the need for a complete separation later arises can lead to drawn out personal and legal battles.

Preparing for the “Business Divorce”

While nothing may be able to save you from the stresses involved with owning and operating your new venture, taking a few preventative steps during the formation phase of your company’s lifecycle may save you from a great deal of frustration and expense later. Any entity which utilizes a two party 50/50 ownership structure creates an inherent risk of deadlock between the parties. Generally, as it relates to “fundamental matters” (as defined in the entity’s operating agreement) the parties should attempt to reach an amicable resolution but include termination provisions to be utilized in the event the parties are unable to reach a satisfactory resolution. Often as it relates to “fundamental matters” a prescribed time will be established where the inability to reach agreement will be documented while negotiations and an effort to reach a compromise continues (e.g., two or three consecutive meetings or months). The underlying principle behind the use of deadlock provisions is that a successful business venture should not be destroyed solely because the two partners are unable to agree on a fundamental issue and each partner should be able to exit the venture and receive a fair value for their interest. While the options are endless in drafting exit provisions in the event of deadlock, there are a few provisions which are commonly used to terminate one party’s interest. These options are summarized below:

  • Multi-Step Termination: This approach utilizes a more formalized dispute resolution procedure and may include discussions between the parties, followed by non-binding mediation, followed by binding arbitration where a fair value is set by an arbitrator (who generally utilizes a business appraiser) and one party is directed to sell at that price. This option is utilized in a belief that the parties in facing a third party determination will reach a reasonable solution, hopefully before one party is directed to sell their interest.
  • Texas Shootout (or if modified a Dutch Auction): This option requires each party to send a sealed all-cash bid to a third party stating the price at which they are willing to buy out the other party’s half interest. The sealed bids are then opened together, and the highest bid “wins” the shootout and buys out the loser’s half interest at the price indicated in the winner’s sealed bid. A Dutch Auction is a variation on the Texas Shootout where each party supplies a minimum price for which they would be prepared to sell their half interest. The higher bid “wins” and then buys the loser’s half interest at the price indicated on the loser’s sealed bid.
  • Shotgun Provision (aka Russian Roulette): This provision requires one of the two parties to serve a buyout notice on the other party, wherein the serving party will provide a buyout price at which it values its half interest in the venture. The party receiving the notice has the option to buy the other party out at that price, or must sell out to the serving party, at that price. If one party decides to serve the buyout notice, it is in their best interest to make a fair offer as otherwise the receiving party can turn the offer against them and buy out their interest at the determined buyout price. Payment terms (all-cash vs. cash/note) may also be established to protect the weaker financial party from a situation where a cash-strapped party is served a buyout notice at a low price because the serving party knows of the receiving party’s financial inability to buy out the serving party.

In addition to the foregoing contractual provisions, a member may always petition a court for judicial dissolution under Idaho Code Section 30-6-701(d)(ii) if it is “not reasonably practicable to carry on the company’s activities.” However, much like the results from an arbitrator under the multi-step approach, the results from a judicial dissolution can be unpredictable and may prevent either partner from continuing a profitable venture.

The corporate attorneys at Hawley Troxell are well attuned to the issues that often arise in a two party ownership structure and are ready to help protect against the issues that may arise from future deadlock. For more information, please contact a member of our Business group.