The Importance of Mandatory Dissolution Provisions in Agreements Among Co-Owners
When co-founders of a startup are forming their entity and putting their founder agreements together, one issue that is often overlooked concerns the resolution of deadlocks or dissolving the business if the co-founders are unable to co-exist. By the time many founders figure out the importance of this issue, the honeymoon phase of their relationship with their co-founder(s) has worn off and the ability to extract themselves from the business (or their co-founder(s)) has become significantly more difficult and expensive.
While buy-sell provisions are standard in written agreements among co-founders to address deadlocks or separation, in practice they are often of limited value and rarely utilized. The valuation methodologies in buy-sell provisions are frequently dated and they sometimes lack the mechanical detail necessary for a founder to trigger without simply instigating interpretive disputes with other co-founders.
For example, we recently saw a buy-sell provision in a contentious situation where it was not clear whether events triggering the buy-sell had occurred, and therefore subject to competing interpretations between the co-founders.
Nor should founders rely on judicial dissolution statutes under state corporate, partnership or limited liability company acts as a practical avenue to dissolve their business relationship. Many of these judicial dissolution statutes require costly litigation to be utilized and even then, there is often no section of the statute requiring a judge to formally dissolve the business.
However, unlike an impractical buy-sell provision or an arcane judicial dissolution statute, a mandatory dissolution agreement among co-founders is intended to provide the principal co-founders with a right to dissolve the business in a relatively cost-effective and pre-agreed upon manner from the outset (and likely when the co-founders are thinking more objectively than is often the case when their relationship may have soured).
Think of this like a pre-nuptial agreement among business partners. This dissolution arrangement should be negotiated and written at the beginning of the relationship (not the end) and should be included in the body of the operating or partnership agreement (for LLCs and partnerships) or the shareholders agreement (for corporations). We sometimes advise that a separate “Dissolution Agreement” be attached as an exhibit to the shareholders or operating/partnership agreement.
Key Provisions for Dissolution Considerations Agreements
Appointment of a Liquidating Trustee* and Authority to Wind Up. The liquidating trustee is responsible for carrying out the winding up of the business. Typically, one co-founder is appointed the liquidating trustee, but there can be more than one and the co-founders can agree to take on shared responsibilities.
Regardless, the principal co-founders should all agree on the specific wind-down procedures, and when and how they are to occur. *As a quick note, reference here to a “liquidating trustee” is a term of art – I am simply referring to the person or persons authorized to take wind-up actions required for a dissolution (in practice that person might be a general partner, manager, CEO, etc.).
Accounting; Financial Statements; Taxes. The co-founders should agree on who the accountant will be to prepare the final books and taxes for the business, and it is advisable to agree that they will be prepared and filed in accordance with the historical custom of the business. This helps eliminate the ability for co-founders to argue over accounting and tax items where prior custom has existed.
There should be a deadline date by which the accountant for the business is required to make final tax filings in order to prohibit any one co-founder from unnecessary procrastination or otherwise attempting to prevent or delay the final completion of financial and tax matters.
Capital Contributions. The co-owners should include a provision that requires the payment of certain additional capital contributions in connection with various creditor obligations and expenses and other payments during the winding up process, and the process for calling and making those contributions.
Division of Company Assets. The dissolution agreement should establish how distributions of cash and other business property will be handled during the winding up period and upon final liquidation. Typically, distributions of cash would be handled in accordance with the applicable distribution provisions contained in the operative agreements among co-founders (such as an operating agreement).
Consideration should be given to whether distributions should be limited (or prohibited) during the dissolution period while vendors or creditors are owed money. Depending on the situation, the division of other business property may be in a manner that differs from percentage ownership or historical distributions. If so, this should be spelled out.
Non-Disparagement and Restrictive Covenants. A mutual non-disparagement clause is advisable, but non-compete and non-solicit agreements are generally not included to allow each co-founder to continue in the business for his, her or its own account following (but not before) the termination of the company or partnership.
Costs and Expenses of Winding Up. The agreement should specify how all costs and expenses arising out of the wind-up process will be split among the co-founders, and deadlines for their payment should be established. These costs would typically be split based on the ownership percentages of the co-founders and/or however historically split among them pre-dissolution.
Indemnification. Each co-founder should be obligated to indemnify and hold harmless the other co-founders for all losses incurred because of the indemnifying co-founder’s breach or failure to perform any of its duties and obligations under the dissolution agreement.
Dispute Resolution. As is prudent with any other contract, the parties should specify a forum for dispute resolution, whether a court venue, arbitration, or the assignment of disputes to a third party, such as an independent accounting arbitrator for any disputes over the final preparation of the financial statements or tax returns. We also normally advise on the inclusion of an attorneys’ fees recovery provision by a prevailing party which is helpful to hold each co-founder’s feet to the fire in ensuring that it does what it is obligated to do under the dissolution agreement.
A mandatory dissolution agreement can provide co-founders of a closely held business with a relatively streamlined, cost-effective and balanced manner of exiting when the business is not working out or the co-founders are not getting along. While the parties are always free to agree to a different deal outside of the dissolution agreement, when no such deal can be struck, the dissolution agreement will provide a baseline from which the founders can separate equitably and efficiently.