Business Divorce: How to Proceed When Founders Need to Split Up

I’ll assume, in answering this question, that the founders didn’t plan for departures and separation when the formed the business.  That’s generally a good idea (see my discussion of “Business Pre-Nups”), but if it wasn’t done, it can’t be helped.

I’ll also assume that the separation will be by agreement of the parties, rather than by legal maneuvering.  If the parties can’t agree and a non-consensual solution is needed, the possibilities and the outcome will depend on how the form of business (e.g. corporation, LLC or partnership), where is was formed (e.g. Delaware or California), what, if anything, the governing documents say on the question, and what the parties have already said and done.  If the situation is headed for a fight, an experienced lawyer needs to look at all the details and help develop a practical strategy.  There might be a relatively easy way to sideline the troublesome person.  If one of the parties is truly irrational, however, fights are likely to end up in court or festering for a long time without any resolution.  In the worst case scenarios, the rational option may be to move on to a new business idea with different founders and an important lesson learned.  Court cases can hold up the business for years and can cost much more than the parties are likely to get out of them.

With those assumptions, it’s important to focus on the problem as separation between people who aren’t seeing eye-to-eye, rather than “getting rid” of someone.  The practical upshot may be the same, but psychology is important.  If you want someone to reach agreement with you, it’s usually best not to make them think you’re trying to kick them out.  If the other person gets their back up, it will be much harder to agree on anything down the line.  Be aware of the strengths of your position (if there are any), but don’t get carried away.  It usually costs money to enforce your rights and fighting is generally more expensive than agreeing.  Revenge and domination can be emotionally satisfying, but they’re rarely good business.

So let’s assume the co-founders are practical people who realize there’s and problem and are capable of talking reasonably about solutions.  There are several different ways to separate:

The simplest is for one founder to stay and the other to leave completely.  In most cases, this means paying something to the departing founder.  It may make sense to let the departing founder keep a minority equity position.  The advantages are that the remaining founders don’t have to come up with cash, the parties don’t have to agree on what the business is currently worth and the departing founder can hold on to some hope of profiting from the business.  The downside is that a disagreeable outsider will remain inside the business.  It’s possible to control the risk with a shareholders’ agreement.  For example, the departing founder could agree to vote with the remaining partners on director elections and major transactions.  But equityholders always have some ability to make trouble, so a clean separation is best.  If the parties can agree on a price but don’t have much cash, it’s worth considering paying the departing founder with a promissory note.  If the business plan calls for outside investment from angels or VCs, however, using debt requires some thought.  On the one hand, angels and VCs take a dim view of using their investment cash to pay off long-gone founders.  On the other hand, they also don’t like troublesome stockholders hanging around.  Ideally, the note should be freely pre-payable and the remaining founders should be prepared to pay it out from their own cash (or by taking a hit to their own equity in a future financing), if necessary.

If you can’t agree on who should leave, the next thing to consider is splitting up the business.  Whether this is practical or not, depends entirely on the business and the founders.  Typically, the main issues you need to address are dealing with the property (physical and intellectual), the co-founders’ future business activities, and the employees (who is going with which founder).  Try not to get bogged down in false either/or decisions.  It’s often practical to share the use of property through leases and intellectual property licenses.  Likewise, it often makes sense for both founders to carry on the same business in different geographical areas, different industries or different applications.  Just make sure the separation is clean enough that you won’t be getting in each other’s way.

It’s worth emphasizing that a competent lawyer is necessary in a situation like this to make sure whatever is done cleans up the mess, rather than making it worse.  Getting a clean, enforceable separation that will produce the results you want (including tax implications and title to IP) is simply not an easy DIY project.  It is best to involve a lawyer before starting serious discussions, to make sure the discussions proceed in legally workable ways.

Ideally, each of the separating founders should have a separate lawyer.  If that’s not practical, the lawyer will generally insist on representing only one person in the transaction.  That person might be the business entity, rather than any of the individual founders.  FYI, a lawyer who doesn’t bring up this issue at the outset is probably not competent.