Settle disputes before they happen by drafting effective governing documents

There are misconceptions that people have at the outset of a business relationship that, over time, can present difficulties for the entity they create.

“People enter into a business partnership believing that the relationship is premised upon and strengthened by their personal friendship, and that their personal friendship will steer them through tough times,” says Christopher Passodelis, Jr., a shareholder and co-chair of the Litigation Services Group at Sherrard, German & Kelly, P.C. “Unfortunately, personal friendships deteriorate rapidly when disputes arise as to the direction of the company. That often leads to hostility that pollutes and corrupts. The reliance on friendship is misplaced and needs to be taken out of the equation.”

When entering a business relationship, he encourages partners to create governing documents that set the rules that guide the actions of a company from the start.

Smart Business spoke with Passodelis about governing documents, why they are important and what they should include.

What documents should shareholders prepare at the outset of a relationship?

Operating, Partnership and Shareholder Agreements set the rules that guide how a company will be run, creating, in essence, a roadmap to follow as partners navigate through various circumstances. These foundational documents are otherwise important because they force potential partners to consider and discuss major issues before entering into a formal business relationship. This can help determine if the two potential partners share similar goals. If not, it is better to forgo a partnership before money and time are wasted.

Governing documents dictate the ways in which the company will manage day-to-day affairs and long-term planning, how the company would approach a sale event, and how partners leave and new partners enter the business, among other issues.

They can also set the rules for appointing a board to oversee the business. It is best if the board has an odd number of members who are not closely affiliated with one partner or the other so they can dispassionately help resolve conflicts with minimal bias.

The process of dispute resolution among shareholders must be addressed. The risk of business failure is highest when partners are focused on disputes among themselves rather than minding the underlying business.

What options do shareholders have when it comes to dispute resolution?

To address disputes, build in a resolution process that starts with each side presenting their position at a special meeting with the board to seek their guidance, relying on their independence to decide what is in the best interest of the company. That is akin to an informal mediation.

The next step would be to retain an independent mediator to guide the partners to a resolution. Mediators are professionally trained to help find common ground.

If that fails, some form of litigation is next. Regardless of the approach — arbitration or court — the struggles associated with this last step are rarely worth the effort because it is such a caustic process.

To offer a way out for two partners who cannot get along, an effective solution is to include a ‘shotgun clause’ in the agreement. This gives either party the option to make an offer, to the other, to purchase his or her shares, and the party receiving the offer then has the opportunity to either accept the offer or buy the other partner out for the same amount. It can be a hard decision, but the value that you preserve is higher than the value that you lose in litigation.

When should legal counsel get involved? Does each partner need a lawyer?

The most effective approach is to have the company hire a lawyer who works to reach an agreement that favors the company over any other partner. Individual partners should be represented by their own independent counsel to ensure that they understand the effect of the agreement. Working with unbiased legal counsel in the formative stages can ensure that the terms and conditions in the governing documents are clear and fairly applied to both parties.

Forming an enterprise is serious and should be considered from every perspective from the outset. Separate emotion from the process and rely on governing documents as the guide. When times get difficult, this document will offer a logical way to resolve problems.

Insights Legal Affairs is brought to you by Sherrard, German & Kelly, P.C.