Death by Deadlock

11 June 2018
Death by Deadlock

When two people come together in starting a business (much like when a couple decides to get married) the energy is always high, everyone is giddy about the future of their enterprise and the partners are wearing rosy colored glasses. The last thing they want to think about is the divorce of the business. However, I always tell my clients, use your LLC Operating Agreement or Shareholders’ Agreement, as appropriate, as your business’ prenuptial agreement. You have to think about the worst when everyone is still feeling good about things, because when discord happens, it may be too late to have a meeting of reasonable minds, much like in marriage. Do not take the LLC Operating Agreement or Shareholders’ Agreement lightly, as this is the document that will govern how your business is run and what will happen if there is a disagreement among the members. Many companies do not have these agreements signed or even drafted. Or worse, the partners simply grabbed a form they found online and signed it, without truly understanding the implications. Then something goes wrong, and that document that no one even read, will determine the future of your business or investment in your company. It is important to know that when there is no agreement in place, the Texas Business Organizations Code (the “TBOC”) will govern. The TBOC is silent on many issues, such as partner disputes – thus it will be left to a court to decide, unless the parties reach mutual agreement otherwise.

Lately I have been seeing many issues revolving deadlocks. Here I will attempt to summarize what is a business deadlock and possible solutions to dealing with a deadlock in your company agreements.

What is a Deadlock

A business deadlock occurs when the partners cannot agree on an issue brought to vote, and typically occurs where: (i) a unanimous vote is required, (ii) the partners are 50/50 owners, or (iii) there is insufficient majority to make the decision.

A deadlock over a major issue has the possibility of paralyzing the regular operation of the company.

What to do About a Business Deadlock

According to the American Bar Association, there are five common ways to address a deadlock. Ideally, one of these ways should be addressed in the company’s operating or shareholder agreement, as appropriate, considering the pros and cons of each scenario:

Buy-Sell Provisions

Known in the state of Texas as a “Texas Shootout,” or “shotgun,” this clause allows one partner or shareholder to essentially buy-out the interest of the other shareholder(s) upon the occurrence of a specified event, i.e. one of the partners ceases contributing time to the business. The agreement should contemplate the manner in which the buy-out price will be calculated.

Con: The monetary value of the interest can be arbitrary and the cost of obtaining a valuation of the company for purposes of a buyout can be expensive.

External or Internal “Tie-breakers”

Professional advisors, industry experts, or outside-boards from another sector of the company become the decision makers for the deadlocked issue.

Con: Leaving a third-party to decide on a company matter when the shareholders themselves are the most familiar with the company.

“Rotating/Alternating” or “Casting” Vote Mechanisms

Business partners take turns in holding an additional vote, or a “casting” vote. For instance, one shareholder will have the opportunity to have his/her way in making the final decision when the vote is not unanimous. During the next deadlock, another shareholder will have the casting vote. The granted casting vote is rotated throughout the shareholders and assumes precedence in every following deadlock regarding major issues.

Con:The rotation lists are difficult to draft and often leave the collective group unhappy.

“Put or Call Mechanisms”

A shareholder insinuates a “Put or Call” during a company-defined triggering event. One shareholder is obligated to sell their part of the company, and the other shareholder(s) is obligated to buy it.

Con:Careful drafting of a “Put or Call” scenario and defining of a trigger event is critical, and heavy negotiations are typically followed.

Partition or Sale of the Company or Its Assets

Clearly segregated assets in the company are either distributed, or the company is sold and its revenues split amongst all partners. A third party usually intervenes to ease the process. Pricing and terms are established.

Con:Pricing and terms may be difficult to establish because partners are already in heavy disagreement, and it is difficult to sell a company in a varying economy, while keeping the consistency of the value and structure of the company.

When partners cannot agree on any of the aforementioned mechanisms, or other deadlock clauses, there is a possibility of going to trial to partition the assets or otherwise dissolve the company, however this route would lead to significant time lost, expenses endured, and emotional burden on all parties involved. This would be, death by deadlock.