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Lesson From Court: Pitfalls of a “Backwards Business Formation”

I was recently in Court for a hearing that involved a contentious business dispute. Suffice it to say, that parties will not be doing business together any time soon.

 

This case provides an excellent illustration to individuals and companies considering creating a new business relationship It reveals some of the pitfalls that anyone could fall into. I can guarantee you this, neither my client, nor their former business partner thought that their business relationship would end with a lawsuit.

 

I. Facts;

The basis facts are as follows:

The case surrounds two individuals who entered a business relationship.

Thereafter the individuals formed a limited liability company.

One of the partners solely funded the start up of the business.

Thereafter they could not agree on the written terms that defined their business relationship.

When written business documents were produced by one partner, the other partner claimed “that’s not what we agreed to!” and refused to sign.

Actions were taken and lawsuits filed over control of the Company.


YIKES.

 

 

II. Legal Issues:

There were a jumble of legal issues created out of this “backwards business formation.

Some of those include: Claims for Membership Oppression:  For more about this claim see a previous article: https://jeshualaukalegalnews.wordpress.com/2013/06/08/shareholder-oppression-when-relationships-in-closely-held-businesses-go-bad/

a. Was the party in control oppressing the other member?

b. Because an operating agreement was never agreed, who are the members? MCL 450.4501 provides for a way to admit members, what if those ways aren’t met, and there is no written documents to evidence who owns any interest in the company?

c. If all the parties are members, did one or more breach a duty owed to the Company?

d. Was their an “oral” agreement to pay money?

e. etc…..

– What a mess.  And a mess that needs to be sorted out in Court means a substantial cost in attorney fees to each side.

 

III. Takeaway Lessons:

 

a. Pitfalls of a Backwards Business Formation

This case was an example of what I would call a backwards business formation.

The process should have been:

individuals discuss with their respective counsel the business relationship they want to form, including obligations and rights of all owners:

individuals memorialize their business relationship in writing, resulting in

the formation of the Limited Liability Company, Articles of Organization and Operating Agreement.

 

 

b. Businesses need to be formed based on clear communication ahead of time, and planning for a way out, if things go bad.

If the parties would have memorialized their relationship in writing, then even if the business relationship deteriorated, most likely the parties could agree on a way out. Because the “way out” would be clearly spelled out in the Partnership, or “Operating” Agreement.

One thing is for certain, these parties would have undoubtedly been better suited by consulting legal counsel prior to forming the business relationship. Who knows, maybe if they communicated their intentions, the relationship might never have been agreed to in the first place, to everyone’s benefit.

 

c. Communicating Business Expectations ahead of time in writing can also sometimes avoid entering in business relationships that have the unforeseen potential to end in Disputes.

I have a client who asked me to draft a Joint Venture Agreement a few weeks back. I drafted the document and sent it to my clients.  I met with them a week ago and they informed me that they could not agree on mutually beneficial terms with the other side, so they decided to walk away.  They recognized that they were glad to have a contract that clearly formalized their intentions to present to the other side. The fact that they couldn’t reach an agreement was unfortunate, but it would have been much more unfortunate if my client just signed a form document, or worse, no agreement, and then relied on the other side to follow through with what they perceived the agreement to be.

As I already indicated, such decisions could prove costly in litigating over what is owed.

 

 

Do you have an interesting issue related to business or real estate? I’d love to hear about it.   

Email or call me. Email: Jeshua@dwlawpc.com / Ph: (616) 454-3883.

 

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