Originally published by Winstead.
The fact of the matter is that co-founders spend most of their time fighting . . . But no one talks about it.
Los Angeles venture capitalist Mark Suster. (Read: Fighting Co-Founders Doom Startups)
Setting up a private company on a 50-50 owned basis is typically a bad idea, but many founders of new businesses continue to embrace this perilous ownership structure. We wrote last year about problems that plague 50-50 owned businesses [insert hyperlink], and a google search on the topic produces articles such as: “50/50 Partnerships; Never a Good Idea,” and “Why You Shouldn’t Enter into a 50-50 Partnership.” Venture capitalist Mark Suster explained in a column called the The Co-Founder Mythology that most people form 50/50 partnerships, “because they’re afraid to to start alone.” Mr. Suster advises entrepreneurs to “take the leap” in starting their new company, but to do so without entering into a 50-50 ownership with a co-founder. Mr. Suster states: “. . . I meet far more people who had problems with [their current partner-ship] than founders who didn’t have problems. People just don’t talk about it publicly or in blogs.” (Read: The Co-Founder Mythology)
50-50 Owned Businesses – High Risk for Failure
The evidence backs up Mr. Suster’s negative views regarding the problems with 50-50 owned businesses. In 2013, Noam Wasserman, a Harvard Business School professor, published The Founder’s Dilemmas after studying 10,000 different business founders. According to Prof. Wasserman’s book, 65% of high-potential startup companies fail as a result of conflict among the co-founders. Pairs and groups bring a variety of skills, but there is also more potential for conflict—over the company’s leadership, finances, strategy, credit and blame. (Read: Fighting Co-Founders Doom Startups)
The chief problem with 50-50 owned businesses is the potential for the co-owners to become deadlocked over critical business decisions, which paralyzes the company. As Prof. Wasserman points out, there are many areas of potential conflict that can lead to deadlock between business partners. One frequent area of conflict relates to the perceived effort that each partner is devoting to the business. It is not uncommon for one partner to conclude that he/she is contributing much more time and effort to contribute to the company’s success, and that the other partner is not holding up his/her end of the bargain. A belief by one partner that he/she is carrying a heavier load will lead to resentment and distrust, and eventually, deadlock between the partners over the company’s operations.
According to Prof. Jason Mance Gordon, who writes columns as the Business Professor, “Without certain provisions in an operating agreement (if the company is an LLC) or By-Laws (if the company is a corporation), a straight 50-50 partnership could cause more problems than in it solves. This is because deadlocks on important matters can occur when you and your partner disagree. This leaves the company helpless, unable to continue to function effectively.” (Read: 50-50 Partnerships Are Never a Good Idea)
The critical views about 50-50 owned companies are not unanimous and there are certainly examples that can be cited of 50-50 owned companies that achieved notable success on a long-term basis. In our experience, however, these success stories are the exception, not the rule. The consensus of commentators offering common sense advice to potential company founders about forming new businesses on a 50-50 basis is simply this: Don’t Do It. In the event these cautions are not sufficient to dissuade founders from forming a 50-50 owned company, our previous post discussed a number of steps co-owners can take when they form the company to prevent future deadlocks. (Read: Insert Correct Link)
In addition, if an entrepreneur is being pressed by a potential co-founder to form the new company on a 50-50 basis, there is hybrid approach that the potential owners can consider to avoid future deadlocks, which may be acceptable to them. We did not discuss this option in our post last year, and it is therefore reviewed below.
Sharing Profits, But Not Ownership (Control) on a 50-50 Basis
One way to navigate the problems created by equal company ownership is to structure the financial returns of the business differently than the percentage of ownership. Specifically, the founders can agree that all profits, capital gains and losses, as well as compensation paid to founders, will be shared equally—a 50-50 profits/compensation split. At the same time, the founders can also agree that ownership will be set up on a 51-49 basis, which provides control to one founder, and therefore prevents the company from becoming stymied by a deadlock on important business issues. This hybrid approach meets the “fairness test” in requiring that the partners to share equally in all financial returns from the company.
To protect the minority partner under this type of 51-49 ownership structure, there are several provisions that need to be included in the governance document and also in some form of an employment agreement. These minority-protections are noted below:
- The governance documents need to include super-majority requirements that prevent the majority partner from taking steps unilaterally to amend the Company Agreement or the By-Laws in a way that disadvantages the minority partner.
- The super-majority provisions may also limit the decision making of the majority partner on certain key issues, such as the addition of new partners, changes in partner compensation and/or the sale of the business.
- The minority partner will not want to be treated as an at will employee and subject to firing without cause. His/her termination should take place only on a “for cause basis” in accordance with negotiated provision documented in an employment contract.
- Finally, the partners will need to include a buy-sell provision, which allows for the interest of a departing partner to be purchase if serious conflicts arise in the future.
One important note regarding the hybrid approach is to recognize the potential that, over time, one partner may devote substantially more time to the business and/or one partner may contribute more significantly to the success of the business, e.g., by developing a patent for the company, securing a critical new source of outside funding or securing major new clients. This difference in effort and/or results by one partner will likely warrant payment to this partner of additional financial benefits.
The partners need to discuss their expectations at the outset and, specifically, how they want to address the difference in future payments to one partner. They can agree on a bonus schedule, additional profits distributions or some other financial benefit. This can be handled through the adoption of a formula that applies to revenues or the founders can agree to retain an outside director or to appoint an advisory board with the sole function of deciding on the compensation to be paid to the founders, and the decisions of the outside director or advisory board will be final and binding on the company and on the founders.
Conclusion
The problems with a 50-50 owned business are well-documented and should provide entrepreneurs with pause before forming a company with an equal ownership structure. The hybrid split of ownership discussed in this post provides for evenly divided financial returns and is a win-win alternative. This type of 51-49 ownership structure allows both partners to share equally in the company’s financial returns by agreement, but the unequal ownership places control in just one partner’s hands. The unequal ownership thereby avoids the potential for a deadlock between the partners, which would prevent the business from making key decisions that are essential for the company to continue on a successful path.
Curated by Texas Bar Today. Follow us on Twitter @texasbartoday.
from Texas Bar Today http://bit.ly/2xljIgZ
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