Dispute Resolution in Startups

Introduction

It’s a classic startup story, two friends or co-workers get fed up with their day jobs and decide to start their own business together. Each of the new business partners has different skill sets and will contribute equally to the business. When asked how they should split the business, the answer is always fifty-fifty. While this may make sense at the beginning, later on this arrangement can cause trouble for the business and its owners if they don’t have clear dispute resolution mechanisms in place.

Imagine two entrepreneurs, John and Jess, own a t-shirt company, each with a fifty percent interest in the business. The t-shirt business is treating our two entrepreneurs well, and they decide to expand their product offering – Jess wants to offer socks, but John wants to offer long sleeve t-shirts. As fifty percent owners, neither John nor Jess can make the decision on their own and so no product line expansion occurs.

What can John and Jess do to make the decision without shutting down the business over their disagreement?

Informal Dispute Resolution

There are numerous ways to settle a dispute between business partners. Informal dispute resolution processes are exactly what they sound like and involve the partners working through the disagreement on their own. These methods are less expensive than formal dispute resolution and are the preferred way to settle the dispute if possible. Many corporate governance documents will require that the founders go through informal dispute resolution prior to escalating the dispute to formal resolution mechanisms.

Informal Consultation

The first thing business partners should do when they are having a dispute is simply talk about it. An informal consultation about the issue can often resolve the issue once each partner has had a chance to hear what the other thinks and why. Many dispute resolution clauses in an LLC Operating Agreement require the parties to sit down and talk in an attempt to solve the issue before pursuing more formal dispute resolution mechanisms.

Chance or Luck

Some entrepreneurs prefer to introduce an element of chance or luck into their dispute resolution methods. While less common than some of the other techniques, clauses requiring a coin flip, or a game of rock paper scissors are not unheard of. This method has the benefit of being fun and reminding the partners that not all decisions need to be endlessly debated and scrutinized for the business to be successful.

Formal Dispute Resolution

Formal dispute resolution involves third parties intervening in the argument in an attempt to get the partners to agree on a solution. These methods include mediation, arbitration, and litigation.

Mediation

Mediation is the least formal of the formal dispute resolution processes. In a mediation, a third party, called the mediator, talks to each of the disputing parties and attempts to craft a mutually agreeable solution to the problem. The mediator doesn’t have any ability to force the parties to do anything and can only try to drive them to a resolution by discussing each parties point of view with the others.

Arbitration

Unlike mediation, arbitration is a lot like litigation, and, in the case of binding arbitration, has the ability to make and enforce rulings against the parties. Arbitration proceedings are often presided over by retired judges and the parties present evidence and witnesses just like at a trial. At the end of the arbitration, the arbitrator makes a ruling for one of the parties which can have the same effect as a court decision in the case of binding arbitration.

Litigation

Litigation is the most formal of the formal dispute resolution processes and is by far the most expensive way for business partners to resolve a dispute. Litigation held in state or federal court involves teams of lawyers, court fees, and hours and hours of time that could otherwise be spent running the business. Because of the expense associated with litigation, and because of the substantial public resources required to hold a trial, most courts will require that the parties submit to mediation, arbitration, or both prior to actually going through with litigation.

Forced Exit

When things have gotten to the point where the business partners can no longer work together, it may be necessary for one partner to force the other out of the business entirely. Contractual provisions such as a shot gun clause or drag along rights are common ways of allowing one of the business partners to force the other to exit the company. Compared to informal and formal dispute resolution methods, these forced exit contractual provisions are a nuclear option for solving a disagreement between business partners. These remedies are typically provided by contractual provisions in an operating agreement or other corporate governance document and are not available outside these contractual arrangements.

Shot Gun Provision

A Shot Gun provision, sometimes called a Texas Shoot Out clause, is a way for one partner to force the other to either sell his ownership in the company or buy the other out. In a standard shot gun provision, the offering partner will give notice to the non-offering partner of their intent to exercise the shot gun provision and the price the offering partner is willing to purchase the non-offering partner’s share of the company. The non-offering partner must then decide whether they want to purchase the offering partner’s share of the company for the offered price or sell their share of the company to the offering partner for that price.

Going back to our budding t-shirt magnates, if John can no longer with Jess because she will not stop talking about socks, John could use a shot gun provision to force one of them out. John would offer Jess $300,000 for her half of the t-shirt business at which point Jess would have to make a decision. Should she purchase John’s half of the business for $300,000 and start producing socks for the masses, or should she accept $300,000 for her share of the company and start her own sock empire with the sale proceeds? Either way, John and Jess will no longer be working together in the t-shirt company.

Drag Along Rights

Another way to force a business partner out of a business is through something called drag along rights. If one of the partners wants to exit by selling the company, typically they would need the other business partners to agree to the sale in order to complete the transaction. With drag along rights, a partner that receives a bona fide offer to sell the company can drag the other partners along in the transaction to ensure that the transaction goes through.

Conclusion

Many founders insist on an equal split of the business between the partners. While this can cause problems later on, a well drafted Operating Agreement, Shareholders Agreement, Partnership Agreement, or other corporate governance document can ensure that a fifty-fifty split does not result in deadlock in the business. No entrepreneur starts up a business hoping to utilize a shot gun provision against their business partner, but much like an actual shot gun, it’s better to have dispute resolution mechanisms in place and not need them, than to need them and not have them.

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