December 2009 – Feature: Howdy–”Partner”?

Planning a collaborative business venture to avoid partnership liabilities and lawsuits

By Greg Sater and Benjamin Alexander

Your last three campaigns were runaway successes. Units sold are in the millions “and counting.” The trouble is, you were just an employee, never an owner, and so you’re not the one with the big house on the hill right now. So there you are, having a drink at the ERA D2C Convention in Las Vegas, wondering when you’ll ever have the guts to “go for it” yourself.

That’s when you see “Bob,” a long-time industry insider, and you learn that he is in transition, too. You’ve seen him at all the shows and conferences, and you’ve heard nothing but good things about him. You talk, have drinks, hit all the parties and by the time you stagger back to your hotel, you’re sure you’ve got the basis for a great business venture together. After you get home, you give notice at your job, set up shop and you go to work with Bob on the new venture. When the next show rolls around, that venture is rolling in cash.

Two or three years later, however, things have changed once more. Your hit product has run its course, and you and Bob aren’t seeing eye to eye on everything any more. But Bob’s not ready to give up. You, on the other hand, have had enough, and want out. What happens next?

We’ve seen this scenario countless times. The endings vary greatly. Sometimes, there’s a happy ending–the participants split the money that was made fairly, as well as in-channel revenues, and they go their separate ways. Other times, there’s a bitter, drawn-out lawsuit or settlement negotiation. The biggest differentiator between the happy and the not-so-happy ending is often how the venture was structured at the very beginning. Without careful planning at the start and some fine-tuning and maintenance along the way, collaborations of this kind can result in personal liability to customers and vendors, liability of one participant to another and costly legal fights over control, revenues and assets.

The Risks of Unplanned Partnerships
The biggest risks occur when the participants just agree to do business together and start using a trade name. It’s quick. The business model is simple, the participants know and trust each other and they’re up and running right away without spending money on (gulp) expensive attorneys. As a technical legal matter, however, this kind of arrangement between two people results in a general partnership between the participants–and that can be very bad.

Indeed, there probably is not a riskier way to organize a venture than with a general partnership. It is risky for two main reasons: first, there are a number of legal implications for the partners (some of which we will discuss in this article); and second, because the reality is that these kind of partners usually don’t have a detailed written partnership agreement or, sometimes, anything at all on paper. Even those who may have had the foresight to write something up usually haven’t considered, let alone written, terms to deal with many of the issues that are likely to arise in the future. And in many cases, state law determines terms that weren’t agreed to in writing.

In a general partnership, for example:

• Every partner is personally responsible for all debts of the venture. That means vendors can sue you. Distributors can sue you. Customers can sue you. And it means your personal assets can be used to satisfy those debts.
• Every partner can sign contracts and cut deals binding the partnership, deals for which the other partners can be sued.
• Partners have a fiduciary duty to each other. Usually, the law holds that no partner can run an independent project that is even vaguely related to the partnership’s business without having the partnership’s consent. In our aforementioned story, Bob might be able to claim a piece of your new project if you were to launch something new without him.
• The fiduciary duty also requires partners to tell each other all “material” facts in dealing with each other. If you’ve seen something that would be important for your partner to know, e.g., media test results, you’ll need to make sure that you’ve advised your partner.
• Partners usually will be assumed to have equal ownership.
• If a partner quits, the partnership dissolves; this means that usually there isn’t a way for one partner to buy the other out and continue the same partnership. You can transfer the assets (including transferring contracts that were in the venture’s name) but the process is cumbersome and usually requires cooperation and consent of vendors and distributors.

While some of the rules can be varied by agreement, in an unplanned partnership there won’t be an agreement. Profits will be split evenly until a partner withdraws. The venture then terminates and assets are distributed. Indivisible assets (e.g., patents, trademarks or copyrights) will be jointly owned by the former partners.

The takeaway is that just agreeing to do business together exposes the participants to more risk than is necessary, and will likely cost extra time, aggravation and money when things change down the road.

Better, Cleaner Venture Structuring
There are a variety of structures that can be used for a collaborative venture. The choice among them is driven by a number of factors, including strategic considerations, operational constraints and tax planning.

Limited Liability Companies–“LLCs” allow the members of the company to structure a venture in which all of the rules are defined by an agreement among the members. What the business of the company is (and what it isn’t), who can sign for the company, how decisions are to be made, what duties members owe one another, how profits are distributed and what happens if a member withdraws can all be specified. Most importantly, members generally do not have personal liability for the debts of an LLC. It’s usually a good idea to include a buy/sell for members to buy out each other.

LLCs are formed by a filing with a state government. When forming an LLC, the members should sign an operating agreement–otherwise, you will have many of the same issues as a partnership without an agreement. Forming an LLC and preparing the operating agreement should be done in consultation with an attorney, but it should not be a lengthy or expensive process. We have a standard document package for forming an LLC and a form for preparing operating agreements. We use a questionnaire to gather information about the underlying business deal. That allows us to quickly assemble an operating agreement close to the needed final agreement using standardized alternative clauses.

To enjoy the protections of an LLC, the participants need to pay attention to the formalities:

Keep a company minute book. When members vote, make sure the vote is recorded in the minute book. Hold required meetings of members. Conduct all business in the name of the company. Sign documents in the name of the company. Make sure the full legal name of the company is on all purchase orders, receipts, legal documents and product packaging.

Also, keep company money in separate bank accounts–never put personal money or any other company’s money in the company’s account.

Make required annual filings with the state in which the company was formed.

Corporations–Corporations allow stockholders to form ventures with pre-set rules for governing their companies. Like LLCs, corporations provide participants with a liability shield–stockholders generally aren’t liable for the debts of their corporation.

Importantly, stockholders don’t owe each other the fiduciary duty that partners do. For example, in one important case, two stockholders had started a venture as a partnership, but later formed a corporation. When a dispute arose over one stockholder’s buyout of the other, the departing stockholder claimed that the other owed him a fiduciary duty. The court ruled that once the corporation was formed, the owners, no longer partners, but stockholders, ceased to owe one another fiduciary duties. Be careful, though: a few states impose partner-like fiduciary duties on stockholders in corporations with a limited number of stockholders.

A corporation can, but isn’t required to, have a stockholders’ agreement. A stockholders’ agreement adds an extra, customized layer to the standard rules governing the corporation. If you use a corporation, you need a stockholders’ agreement to deal with many of the same issues that an operating agreement addresses in an LLC.

As with an LLC, forming a corporation and stockholders’ agreement should be done with an attorney, but, again, it should not be a lengthy or expensive process. Also, just as with an LLC, the same rules for formalities apply. In addition, corporations are required to hold annual stockholders’ and directors’ meetings, or have written action in lieu of those meetings.

Contractual Joint Ventures–You can also draft a contract for the specific purposes of the venture. Best used when each party has a very distinctive and easily defined role and the purpose of the venture is narrow, the contract can be a comprehensive joint venture or strategic partnership agreement specifying everyone’s roles and responsibilities, or a license agreement, allowing one party to use the other’s intellectual property. It may require more time and expense initially, but generally needs less ongoing attention. A contractual joint venture by itself provides no liability shield; each party itself should be in the form of an entity that provides that protection, such as a corporation or an LLC.

A Final Checklist
To increase the chances for a happy ending to your collaborative venture, make sure:

There is a written agreement defining the venture.

The venture is either conducted by an entity providing a liability shield (a corporation or an LLC) or the participants in the venture are themselves corporation or LLCs. Corporation or LLCs will always be formed by registering with a state.

All of the necessary formalities are observed–conduct business in the venture’s name, maintain company records and keep the company’s money in its own bank account.

Greg Sater is a partner with Rutter Hobbs & Davidoff, based in Los Angeles. He can be reached at (310) 286-1700 or at gsater@rutterhobbs.com. An attorney at the firm, Benjamin Alexander can be reached at the same number or at balexander@rutterhobbs.com.