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Deadlocks Can Be Deadly for Closely Held Companies

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Establishing and running a family business or other closely held enterprise often represents a dream-come-true for the founders and shareholders. At the beginning, everyone is on the same page. Same company vision. Same philosophy on how to achieve growth. Same approach to marketing and business development.

To preserve both control and the corporate vision, closely held businesses often operate with a small number of shareholders. As the business grows and prospers, it is easy for those involved to wonder: “Why didn’t I do this earlier?”

Unfortunately, business honeymoons do not last forever. At some point, closely held businesses will experience conflict, as pressures on profitable growth, financial management and technology integration tend to cause disagreements. Changes in business philosophies, social relationships, financial resources, etc. can impact shareholder perception of how the enterprise should be run. These shifting perceptions can lead to disagreements on a range of issues such as business strategy, acquisitions, asset management, employee development, market penetration, technology adoption, customer relations, etc.

Closely held and family businesses also come with a strong emotional attachment built on longstanding and, in some cases, intimate relationships. When serious disagreements arise over key issues, these emotional attachments can present wild cards that interfere with the dispute resolution process and prevent the owners from reaching consensus, thus creating a deadlock where no acceptable decision is possible.

This dynamic is especially problematic when there is an equal ownership structure or where family shareholder interests and voting powers are evenly divided. Forming a business with equal partners (or shareholder groups with equal ownership) may offer a false sense of security. At some point, achieving consensus on key issues may become difficult, if not impossible, and the decision process becomes deadlocked.

Minimizing Deadlock

One way to minimize deadlocks in decision-making is to structure the business with unequal ownership and unequal voting power. Think about your company’s ownership and management structure and whether such mechanisms should be part of your governing documents.

Of course, a structure with unequal ownership/voting is not always feasible. When deadlock resolution requires voting and the business is equally owned, a better approach for avoiding / resolving deadlocks is to have shareholder agreements that include provisions to resolve key disputes by a vote of an independent party, or by a group of outsiders designated in advance for this purpose. Owners should identify a trustworthy advisor and consider appointing that person as an independent director tasked with casting votes necessary to break a deadlock.

The stakes can be extremely high: deadlocks can adversely affect business operations and hinder employee, vendor, customer and financial relationships. They can significantly strain shareholder relations, paralyze management and undermine the business and its value. Consider the additional strain on the business with the prospect of expensive, protracted litigation.

In short, a deadlock, with no resolution on the horizon, can cripple the company.

Business partners and shareholders should take steps to ensure that these conflicts can be resolved promptly and without undermining the success of the business.

For those cases where a deadlock has no remedy, the court will serve as final arbiter. However, this should be considered a last resort, as court-ordered resolutions often have negative consequences for all parties.

Planning Ahead

We’ve seen that the best way to approach business transition is to plan for it ahead of time. The same is true for managing conflict and potential deadlock. Business partners / shareholders can take measured steps to minimize future conflicts by adopting mechanisms for mitigating and resolving disputes.

Collaborative-based dispute resolution processes, including guided mediation, should be incorporated in the business formation documents and operating agreements. Later, as the business matures, it may be necessary to modify the business or ownership structure. When this happens, be sure to update the relevant Shareholder and Operating Agreements.

Owners / shareholders should work with legal counsel to develop agreements that address key issues:

  • Roles, duties and responsibilities
  • Required capital contributions.
  • Decision-making authority
  • Procedures for managing disagreements.
  • Increasing / decreasing shareholder interest
  • Business sale or termination

Underlying business agreements should also address mechanisms for resolving serious disputes and avoiding deadlocks.

The harsh reality is that, notwithstanding family ties and the best of intentions, shareholders in a closely held business may have disagreements significant enough to poison the company. This can be mitigated if the shareholders proactively build carefully worded agreements that incorporate one or more clauses providing mechanisms to resolve potential deadlock:

When possible, avoid the cost and anxiety of working through the courts.

The Importance of a Deadlock Clause

Family members who start a business together often fail to consider the prospect of falling out, and when that happens, disputes can become emotional and difficult to resolve. Having a carefully considered shareholder agreement in place with a suitably drafted deadlock clause can help shareholders resolve differences before they seriously divide the family or harm the business. Endeavor to adopt plans designed to avoid or resolve these conflicts at an early stage. Don’t let emotions undermine productive outcomes that should advance both the business and family interests.

Wilchins Cosentino and Novins LLP has been thoughtfully and purposefully designed to offer closely held business owners including family-owned business a breadth of practices including Business Law to provide guidance and counsel from business formation through succession planning. If your closely held business does not have the requisite agreements in place, including shareholder agreements to resolve disputes, contact us.

We welcome the opportunity to be your legal counsel for all matters related to running a privately held business.

This article is not legal advice and should not be taken as such or relied upon as legal advice.

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