‘Prenups’ Are Not Just for Individuals: Protecting Your Client in a Business Divorce

By Byeongsook Seo and Stephanie Kanan 

Not all business partners stay together. Remember Mark Zuckerberg’s messy separation from his Facebook Inc. co-founder? A part of The Beatles’ breakup included business conflicts related to the company they founded, Apple Corps. And eBay Inc. spun off a subsidiary into its own company. What these examples illustrate is that marriages of business interests sometimes do not last. As problem-solvers, it’s the job of business divorce attorneys to help our clients plan for this possibility.

What?! You, as a member of our distinguished profession, are not familiar with a “business divorce” practice? You’re likely not alone. After all, the American Bar Association formed the Business Divorce Subcommittee of the ABA business law section’s Business and Corporate Litigation Committee only in 2013. In fact, we often introduce ourselves to fellow attorneys as lawyers who address issues related to corporate governance, business divestiture, officer and director, and post-acquisition earn-out disputes. Try that as your elevator speech with those who are unfamiliar with our profession.

We prefer using “business divorce” because it immediately brings to mind the mess that may arise from a client trying to split up a business venture or wanting to expel a business “spouse” from control over a corporate endeavor. It can get emotional. It can get nasty. Business divorce clients often admit they wish they didn’t need our services. So, we continue the marriage analogies and suggest clients could have reduced the stress of a business divorce by entering into a solid “business prenup.”

Yes, we know, there is no such thing. But “prenup” is an effective shorthand that helps explain why clients should consider retaining attorneys to draft documents (e.g., bylaws, subscription agreements, partnership agreements and operating agreements, etc.) to serve the same purpose most prenuptial agreements serve for future spouses. A business prenup can help establish how business partners will treat each other and their assets before getting into a business relationship, which can dictate what type of business entity is formed. A well-thought-out prenup can avoid future disputes among business “spouses.” At a minimum, addressing prenup issues may promote earnest discussions about each other’s expectations and interests. Hence, we encourage attorneys to use prenup analogies as a platform for addressing business formation considerations.

Before your corporate client gets hitched, counsel them on why a solid business prenup makes sense. The following are key items to consider.

Unexpected Events: Corporate Ownership Can Change Suddenly

Let’s first address an uncomfortable topic—death. If married individuals die without a prenup or will, the surviving spouse usually inherits the property of the deceased. The death of a business spouse, however, does not mean that the surviving owners of an organization will automatically retain the business interests of the deceased. Ownership in a business usually passes to that person’s heirs. If there is no agreement addressing how the deceased business spouse’s ownership rights should be disposed, the surviving owners could end up essentially married to the deceased owner’s heirs. If the client is comfortable with this possibility, fine. We hope she has met her business spouse’s family before starting the business. Otherwise, clients considering going into business together can agree on how best to treat the ownership rights upon death. A client may want to set up a process of providing an opportunity for the surviving owners to buyout the deceased owner’s interests upon her death. Or maybe, the owners may want to allow the interests of any deceased to automatically convert to an investor interest with no right to make daily management decisions, allowing heirs to inherit the financial benefit of the deceased’s ownership interest with no right to intrude on management of the business that survives the death.

Business prenups may also help your client address a business partner’s actual (marital) divorce. If their business partner is going through his/her own   divorce, the ownership rights in the organization may be transferred to that business partner’s spouse. The prenup could help your client avoid ending up with a partner they never intended to go into business with. Or, at the very least, a prenup could help lessen the impact to your client’s business.

Managing Expectations: Defining Roles and Responsibilities

A business prenup can also address issues that may appear more mundane, like defining the roles and responsibilities of each business partner. Maybe one of the founders of the business wants more responsibility or pay. Unlike real marriages, business spouses can define who will do more; who will do less; and how each will be compensated for their individual role. The prenup can declare who the owners are supposed to rely on, like attorneys and accountants, when making decisions that may affect the business union. This will reduce the likelihood of courts questioning the business judgment of each partner. Business relationships can become strained when one owner is perceived to have overstepped his or her authority. Specifying the roles and responsibilities often helps business partners understand the rules of the relationship and the limits of each person’s power. This avoids ambiguity that can lead to resentment.

A prenup can also address the loyalty (or lack thereof) a partner will have toward the business. Essentially, you can help your client memorialize an “open” business marriage—yes, another marriage analogy. For example, does your client want their co-founder to be able to dabble in opportunities outside of the business without the involvement of others? The corporate-opportunity doctrine may prohibit them from acquiring, in opposition to the business, a business opportunity in which the business has an interest or expectation essential to its existence. But the founders can decide to create exceptions to this policy to specifically allow one partner to pursue corporate opportunities without the involvement of the business. And if your client wants to allow the ability to invite others to participate in the business, the prenup can set procedures to permit such invitations.

Dispute Resolution: Dissolution and Alternatives to Litigation

Regardless of the best plans and intentions, the reality is that sometimes a divorce is unavoidable. It’s no secret that relationships between business owners—or the business itself—can evolve and change over time. And just like married couples, business partners will either grow and prosper together or they eventually find themselves incompatible and ready to part ways. But instead of resorting to litigation when this happens, a business prenup can be fashioned to encourage a more amicable separation. It can include dissolution or wind up provisions specifying the procedure for separation, including the final distribution of assets. It can also require the parties to mediate any unresolved disputes before seeking judicial intervention. And if mediation is unsuccessful, the partners may want to keep the details of their divorce proceedings private. The best way to do that is through arbitration, but those proceedings can be costly. Business partners should be encouraged to consider their options early, when the relationship is still intact, because doing so can allow them to mitigate future cost, damage to the company’s good will, and potential embarrassment, and allow them to agree on the best venue for  a quick resolution.

Final Considerations: Your Clients Should be Proactive, Not Reactive

While the term “prenup” is a convenient shorthand reference for avoiding messy intra-business disputes, its brevity should not imply or suggest that a single document can address all potential business divorce issues. Depending on the entity, business partners may need several documents—which can be complicated and require amending over time—to appropriately address the corporate relationship and potential breakup. That is why it is critical for your clients to consult with attorneys before entering into a business relationship and again as circumstances change.

That said, we are not naive. We understand that businesses want to avoid the costs of retaining attorneys when just getting started, and even more so when the business is doing well. But if a business decides not to invest the time and money to develop the appropriate prenup, they may ultimately pay the price when things fall apart. And when that happens, they may be asking themselves why no one (i.e., you) prepared them for what may now seem like an inevitable result.

Byeongsook Seo, counsel at Snell & Wilmer and Stephanie Kanan, associate at Snell & Wilmer, focus their practices on business divorce. Contact them directly at bseo@swlaw.com and skanan@swlaw.com.

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