One of the most common issues we are consulted about are disputes between business owners, whether it be between co-shareholders of a corporation, “members” of an LLC, or partners in a partnership. Often, a business relationship which began with trust and cooperation devolves into distrust, suspicion and outright hostility. Many times, the breaking point comes at a critical juncture in the life of the business—perhaps at the moment when the business is about to “go live,” a large contract is about to be signed, or a new round of capital funding begins. Usually, such timing is not coincidence.
These shareholder disputes or partnership disputes are frequently called “business divorces”—and they can be as heated and contested as actual divorces. Here are some of the most common scenarios we see.
Supposed “cancellation” or “revocation” of shares
There are generally two ways a corporation can raise money: equity or debt. Debt can sometimes be undesirable, or loans can simply be unobtainable for an upstart business. The founders then turn to equity: the exchange of shares (a/k/a stock) for an investment of money.
Typically, when the business was first formed, the founders distributed the corporation’s shares among themselves. Later, if more money must be raised through the selling of shares, it means the founders must sell some of their own stock, or else issue more company shares (think of a mint simply deciding to print more money), thereby diluting the existing shares. Faced with this unappealing choice, we often see that a desperate founder will attempt, illegally, to “cancel,” “revoke” or otherwise take away a co-founder’s shares and give them to an investor—usually based on a flimsy pretext which holds little or no legal validity. Your shares are a property right, and just like any other property right, generally someone cannot take it away without your consent. See, e.g., California Corporations Code 409.
LLCs are structured very similarly to corporations, except the shares are called “membership interests.” Replace “shares” with “membership interests” above and the same information generally applies to LLCs.
Denial of ownership interest
In other cases where the original business formation was not well documented (such as where no share certificates were issued for a corporation), sometimes the offending founder will simply deny that that his/her co-founder holds any shares at all. Or sometimes, he/she will acknowledge share ownership, but in a lesser amount than originally agreed. Bottom line: the offending founder suddenly develops “amnesia.” The offending founder will essentially dare the co-founder to “prove ownership”—hoping the co-founder will not be able to find any evidence of the original agreement.
Locking out or taking physical control of assets
Sometimes the offending founder will physically lock-out his/her co-founder. The other owners will try to enter the business premises one day and suddenly find that the locks have been changed, the computer passwords altered, and/or the bank account access changed.
In another variation of this tactic, the offending founder will “go rogue”—start selling off expensive business assets and keeping the sales proceeds; or funnel business prospects to his/her own side business. There are many variations of this.
Freeze-out
Finally—and perhaps this is the most insidious method of all—sometimes the offending founder will simply stop letting the co-founder share in any benefits of co-ownership. If you were a corporate officer receiving a salary, you will be fired, but you keep your shares. You still technically have an ownership interest “on paper,” but you aren’t receiving any benefit from your ownership. Perhaps the offending founder is distributing all of the profits of the business to his/herself and other insiders in the form of salaries, rather than dividends, leaving nothing for you. You can’t sell your shares to a third party because there is no market for stock of a small closely-held company, especially where it is not issuing dividends, and your co-founder refuses to buy you out at a fair price.
Closing thoughts
The scenarios discussed above are just some of the more common ways business owners sometimes attempt to take advantage of their fellow owners. There are many other ways, and often these methods are used in combination.
Every case is different, but generally these tactics violate the co-founder’s legal rights. Likely, if you have experienced one of these tactics in a California business, you can take legal recourse. Knowing how to take advantage of the timing of your enforcement efforts can be critical. As stated above, these disputes often arise at a critical moment in the life of a business. Many times, this timing can be used to your advantage; such as when capital is being raised or a big contract is contemplated. Please feel free to consult us for more information.
If your business partner dispute is more in the nature of you being scammed out of your investment money, see here.
Brodie Smith & Anthony Lanza, litigation and trial attorneys, have developed a focused practice area for business litigation, in both state and federal courts in California. They can be contacted at (949) 221-0490 or here.
Business “divorce” cases often lead to both sides suing one another. For information about whether it is advantageous to file your lawsuit first, see this blog post.
The information in this blog post does not constitute legal advice, nor create an attorney-client relationship. Laws constantly change, and this information may become outdated; moreover, the information here is only a limited and general overview and may omit some aspects of law. It is provided for discussion purposes only; not to be relied upon in making real-world decisions.
