Many businesses are conceived at the kitchen table, in a garage, or on the back of a cocktail napkin. At that moment, the world is your oyster and all you need to crack it open is capital. Taking on a partner or shareholder is just a necessary step to realizing your vision, right? Well, maybe. The thing is, decisions made at business conception can have really long-lasting consequences. What seems like a kind offer from a friend or your brother-in-law to get you off the ground can become a real pain in the….uh…“neck” when your business grows and matures.
It is true that equity partners are by far the most common source of capital for start-ups. Investors are taking a lot of risk when they back your “vision” and they expect (and frankly deserve) returns that will compensate them for that risk if your business succeeds. Fair is fair.
However, the ideal partner at inception may not be the ideal partner longer term. None of us gets married expecting to get divorced; unfortunately, over 50% of us do. That doesn’t mean that we should avoid all contact with attractive people and use social networking as our only source of interaction with the outside world. It DOES mean, however, that we should be thoughtful about relationships we form and plan for ways to modify those over time. When starting a business, this means developing a rock-solid shareholder agreement. Sound too New Agey? Here’s why you should care:
- Voting rights are a powerful tool that may be used against you.
Let’s say that you and your college roommate develop a great business concept and decide to be equal partners. Fast forward ten years. You want to invest in a new business line to diversify your reliance on one revenue source and grow the business faster. Your partner just wants things to stay as they are. See how messy this can get? If you’re equal partners, (or even if you’re not but your organizational docs require a super-majority to approve major investments), you can burn time, energy, and personal relationships while opportunities go to others.
- Minority partners can create majority-sized problems.
Have you heard the adage, “the squeaky wheel gets the grease”? Even a 10% shareholder can become a drain on your time and sanity if he or she doesn’t share your vision or seeks to be “helpful” by wanting to be overly-involved. In some instances, they can seek to block acquisitions or initiate litigation questioning your judgment after the fact. Best case is an expensive hassle, and worst case is a missed opportunity.
- Potential buyers may not find you attractive.
If you have a fractured ownership structure where there is a lack of consensus about key decisions (like a sale), buyers may get fatigued with negotiations and seek an easier target. If you are offered a price for your business that you believe is generous, the consequences of an opposing shareholder are meaningful and potentially permanent.
So what to do? Here are a couple of things to keep in mind when you’re building a business and formulating your shareholder agreement.
- Consider dating, not marriage.
Some partners, particularly family members, are truly altruistic in their desire to help you get your business established. Don’t assume that equity is your only alternative; a loan with a reasonably flexible repayment structure can help you get your business started and provide a clear path toward separation. If you do end up in a situation where you have a family member as shareholder and it’s not working, there’s little else but to work on your assertiveness and confidence skills and get them out. Yes it will cause problems short term, but long term is always for the best.
- Get a pre-nup.
The corporate equivalent of this is a buy-sell agreement. This provides upfront the roadmap as to what happens if a co-owner chooses to leave, is forced to leave, or even leaves this earth. It can establish the processes to be used for valuation, provide you with a “Right of First Refusal” if a partner decides to sell, and greatly reduce the stress and cost of a business break-up.
Thinking through the ownership structure of your business before you start is ideal. However, rationalizing your ownership structure in the absence of a potential transaction is also a good plan. No matter how long you’ve been in business, it’s never too late to develop a strong, detailed shareholder agreement. You won’t really want the agreement until you desperately need it, but when that time comes, you’ll give your past self a pat on the back.