How to Do a Business Divorce

Introduction

Like marriages, many business partnerships do not last forever. Sometimes it is because one partner failed to hold up their end of the deal, and sometimes it is because the partners’ interests diverge over time. At the end of the day though it does not really matter – they need to split up.

When this happens the former partners are well-advised not to try to prove that it was the other’s fault. The only way an argument like that gets resolved is in court, and if the former partners are in court it means they are spending plenty of money on attorney’s fees and wasting their time in litigation rather than working on their businesses and making money. In any event the court is essentially going order the parties to simply split everything more or less equally. Why not just skip the time and money otherwise wasted on legal expenses and court proceedings and settle-up front with terms everyone can live with?

In other words, the law will order the assets sold and the creditors paid off from the proceeds of the sale, and if there is anything left over the partners will take an amount equal to their ownership percentage. Is it really necessary to have a judge do that? Moreover, if the court is doing that, it eliminates the possibility of a more efficient outcome, such as one partner buying out the other.

The moral of the story is this: It is always better to settle these disputes outside of court if possible. The key is agreeing on the numbers, or in this case, a percentage of who gets what. Once that hurdle has been cleared, it is mostly a matter of working through the details below.

Checklist of Items That Should Be Addressed in a Business Dissolution

The list below is intended to cover most of the issues former partners need to address when splitting up, with the caveat that each case is different and certain of the following issues need not be addressed while others should.

Sustaining or Dissolving the Legal Entity

Assuming the partners were doing business as a corporation or limited liability company (LLC), the former partners must decide whether the original legal entity will live on under the control of one or more of the original partners while the departing partner(s) create a new legal entity. If not the original entity should be dissolved and the separated partners each create new legal entities of their own. In either case, certain documentation must be filed with the state.

The most important point to consider in regards to this issue though is that if the original entity lives on, then the departing partner will continue to enjoy to the limited liability shield for the business’s contracts and torts made both before and after he or she has left. If the original entity is dissolved, the benefit of that corporate structure in terms of its liability shield will disappear.

If the partners were not doing business under a legal entity at all, then the paperwork requirements will be substantially smaller, but the partners will continue to be fully liable for each other’s acts and omissions that occurred while the partnership existed.

The decision regarding the name and legal entity first because it will impact many others.

Banking

Most businesses should have at least one checking account that serves as an operating account into which the business income is deposited and its expenses are paid. If the business lives on, than the remaining partners should gain exclusive control over those accounts as soon as possible while excluding the departing partners from access.

Debts and Liabilities

If the business is closing altogether, outstanding liabilities should be paid as soon as possible while new expenses should be kept to a bare minimum. Once all of those expenses are paid, remaining assets should be distributed to the partners.

If the business will continue without one or more of the previous partners, then it generally must relieve the departing partner of responsibility for any existing debts. This can be difficult if the prior partner was a personal guarantor of the partnership’s debts. In that case, the continuing partners should seek to refinance the debt so as to relieve their former partner not only of any continuing liability, but for any residual control he or she may have over the debt.

Credit

Almost all businesses in this day and age have open lines of credit or credit cards (collectively referred to herein as “LOCs”) with which they pay their operating expenses. Those LOCs should be paid off and closed as soon as possible if the business is dissolving entirely.

If the business is going to continue on after one or more of the partners leave, then the creditor/bank should be notified immediately so that the departing partner can be divested of control over the LOC and relieved of any personal guarantees that he or she may have agreed to as a form of collateral.

Customers and Clients

Unless a business is part of a widely-marketed brand, the lifeblood of most businesses, i.e., their source of future income, depends on the owners’ established network of referral sources and former customers or clients. When a partnership ends, the partners should quickly decide which customers or clients belong to whom and document it.

Employees

In returning to our marriage analogy, the employees of a business are somewhat similar to the children of a marriage. They depend on the partners for their livelihood and the law (not to mention common decency) puts their interests before the partners in the event of a break-up. As such, once a decision has been made to separate, the employees should be notified and given assurances as to how much longer they can depend on their paychecks and when they should seek other employment if necessary. There are many traps and pitfalls for owners to accidentally stumble into in this area, and all partners would be well-advised to seek expert guidance on how to handle employees terminations and layoffs, if applicable.

Data

The control over a company’s e-mail, website, databases, and social media platforms are almost equally as important as control over its finances. Modern business cannot function without these items. As such, it is key to a continuing business’ viability that it retain control over its data. If the accounts for any of these databases are under the control of a departing partner, that control must be surrendered immediately. If the business is being dissolved, then the accounts should be shut down and data transferred as soon as possible to the partners’ new entities.

Office Space

Most businesses rent their office space. If the business closes before the natural termination of the lease, it must seek the landlord’s permission for early termination or be prepared for a lawsuit in which landlord has the right to collect the unpaid balance less any rent they might collect from new tenants. This is especially important in cases where the landlord has had the individual owners sign personal guarantees for the lease that make the owners individually liable even if their business no longer exists.

Inventory, Equipment, Accounts Receivable, and Intellectual Property

The physical assets of a business, including its equipment and inventory of unsold goods must be divided. So too must the right to collect any unpaid customer or client accounts be assigned amongst the former partners. If the partnership created any intellectual property, such as patents, trademarks, copyrights, or trade secrets, the ownership of those assets must also be explicitly divided.

Insurance

Businesses usually have one or more policies of insurance regarding liability, health, workers compensation, professional malpractice, directors and officers. If the company is going to continue, then the insurance carriers should be notified of the departure of one or more partners as that may reduce the cost of the policies. If the business is closing altogether, then the carriers should also be notified so that business does not incur expenses for unnecessary policies.

Licenses

Most businesses are regulated by at one or more governmental agency and must maintain licenses to operate with those agencies. In almost all cases, the regulating agency should be notified of the change in ownership structure.

Branding

If the business will continue on without the departing partner, it should consider whether or not it should alter its name, website, logo, letterhead, business cards, and other forms of branding to reflect that change in ownership.

Existing Contracts

Most businesses have ongoing relationships and therefore existing contracts with outside vendors. These can include everything from telephones and utilities to water and coffee. If the company will continue on as without restructuring, then the contracts can generally be left undisturbed. However, If the corporate entity is terminated, those contracts should be extinguished or assigned to a successor entity.

Taxes

Businesses usually have a tax identification number assigned to them by the Internal Revenue Service. If the entity continues under its existing corporate structure, no new tax i.d. needs to be issued and a corporate tax return can be filed just it was in the previous tax year. However, if a new corporate structure is created then a new tax i.d. must be issued and a final tax return must be filed for the old corporation.

Conclusion

Simply put, business divorces are unpleasant. They key to getting through as unscathed as possible is to accept that the outcome will never be perfect and that it is always better to make a deal with your former partners than drag the matter into court. In either event, the myriad of legal and business issues that must be confronted can be handled more efficiently and effectively with good counsel.


Noah Green is an attorney and partner at the firm of Green and Stewart, P.C. in Pasadena, CA. He can be reached at (626) 395-7686 or noah@gspattorneys.com.