iHindsight can be a wonderful thing, especially if hard-earned lessons are adopted by others who are willing to learn from past mistakes. When private company owners and investors share with me some of the wisdom they have gained from their past dealings with business partners, they often cite the same three mistakes they made in relationships with their partners. In summary, these are (1) choosing difficult partners, (2) failing to enter into well-crafted buy-sell agreements with their partners at the outset, and (3) doling out ownership interests (equity) in the business too freely to new investors.
Avoiding Bad Apple Business Partners
The importance of picking good business partners cannot be overstated. Problems with a company’s services or products can be fixed over time, but a partner who is dysfunctional or who is hostile to the business can create conflicts and distractions that ultimately destroy the company. Of course, no one agrees to enter into business with other partners they believe to be dysfunctional. Instead, people become partners with others optimistically and with a sense that their interests and business objectives are aligned. It is only later they are dumbfounded to learn that their partners are selfish, inflexible, disruptive, or worse, unethical and uncontrollable.
Unfortunately, there is no fool-proof test to apply that will guaranty that a new business partner will be a great longtime fit for the business. But there are two approaches to consider before going into business with someone new, which will lessen the chance of picking a bad business partner. These two approaches focus on, first, checking known attributes of the potential partner and, second, avoiding serious red flags discovered as part of a due diligence process.
The first approach focuses on four aspects of the potential partner, which can be gleaned from this due diligence. The first aspect is experience: Does the potential new partner have a track record of success at other companies, and is he or she well regarded by former employees? Or does the potential partner’s past reflect a string of problem companies and fraught relationships with former employees? The second aspect is flexibility. Change is a constant in business, and a partner who is rigid and resistant to change is likely to be a difficult partner. The third aspect is reliability. Success happens when partners show up consistently and reliably and demonstrate accountability. The final quality may be the most important: integrity. Partners need to be open, honest, and loyal to each other – the opposite is not just bad for relationships, but detrimental to the company. It is a challenge to determine whether a potential partner has these qualities, but a discussion of these qualities should be discussed by the partners. A process should take place where some of the potential partner’s former colleagues are asked if this person exhibits these qualities or whether there are concerns in these areas.
The second approach is the red flags test. Every potential new partner should be subject to a formal background check, which also needs to include a credit report. In addition, each potential partner should be asked about all past and pending litigation in which they have ever been a party, as well as whether they ever filed for bankruptcy. The time and expense of conducting these tests and background checks are well worth it, and a potential partner who balks at providing this information is raising a red flag right at the outset.
Get a Business Prenup in Place, Adopt a Buy-Sell Agreement
We will not delve deeply into buy-sell agreements here as we have discussed them in the past, and you can read about them in previous posts here and here. Suffice it to say that it is not uncommon for business partners to become at odds, and when their conflicts are irreconcilable, they will want/need a business divorce. If the partners have wisely put a partner exit plan in place, they will have a buy-sell agreement to follow that governs the process for the partner’s exit, which will avoid or limit headaches, heartache and expense.
The buy-sell agreement should cover (1) when the agreement can be triggered by the parties, (2) how the ownership interest of the departing partner will be valued, (3) the terms for payment of the purchase price to the departing partner, and (4) what happens in the event of a default in the payment of the purchase price.
Retaining Majority Control Over the Business
The final mistake takes place when the company’s founder needs to secure additional capital to grow the business. To obtain this growth capital, the founder will issue stock or units to new investors, which dilutes the founder’s ownership percentage. As the investments mount and the extent of the dilution increases, the majority of the business may become controlled by the new investors. I have represented multiple founders of private companies who were later removed by the new investors from any role in the continued management of the company they had created. This undesirable outcome is likely be a source of significant disappointment for the founder, as well as bad for the business.
Growing companies will need to obtain capital, but that does not mean that the founder needs to cede control of the business to new investors. The founder can negotiate to ensure that he or she remains in control by requiring the investors to accept a minority ownership share. The tradeoff is that this will likely reduce the types of investors who are willing to invest in the company on this basis as many private equity firms will not invest in a company if they do not secure control over the business when they make their investment.
Even if the founder is willing to accept a loss of control over the business to obtain the new investment in the company, there are some fallback positions that the founder can take. The founder should consult with experienced counsel to evaluate the available options, which will enable the founder to maintain continued rights regarding the management of the business while also protecting the founder’s ongoing economic stake in the company.
Conclusion
It is often said that those who do not learn from history are doomed to repeat it. In the private company space, some of the lessons to be learned from owners and investors include (1) taking the time and effort to conduct due diligence regarding potential business partners to avoid being stuck with bad partners; (2) negotiating and adopting a buy-sell agreement at the time the new partner invests in the business to ensure that a business divorce can take place as necessary in the future; and (3) for company founders, if possible, seeking to avoid growing the business in a way that turns over control of the company to new investors. Taking these steps will help to avoid, or at least limit, major problems in the future with business partners.
