Summary of Issue:
Two people decided to start a business together. They were friends, entrepreneurs, and believed they would both contribute in different ways to the success of the business. One partner was the “rainmaker,” and the other was the management/administrative genius. They both agreed that they should each have an equal say in the operations of the business and, since they saw eye-to-eye on everything, there would be little to no disagreement anyway. They visited an attorney and established the corporation reflecting a 50/50 ownership and decision-making structure. Both owners were content that they had equal control and ownership. They proceeded to buy an existing business and began operations that turned out to be wildly successful.
What Could Possibly Go Wrong?!
In short, everything can go wrong in this scenario and, too often, it does. When nobody has “control” or the ability to break a tie, nobody has the necessary authority. Starting out, both parties feel like they have mutual and equal control but, in a dispute, neither party has the control to move past a disagreement. The vagaries of 50/50 ownership are usually exposed at one of two extremes: 1) The business becomes successful producing a lot of cash flow, or 2) the business struggles or even begins to fail. Either of these two extremes tend to produce disagreements that cannot be resolved in a 50/50 environment.
In this case, decisions regarding distributions of profits, preserving cash for working capital and growth, and expansion plans were frozen by the 50/50 tie. As is usually the case, one of the two partners decided to step into the control role and began making decisions that forced the other owner to either ignore, accept, or challenge those decisions. And, as in most similar cases, the decision to challenge was deferred as long as possible but eventually was unavoidable. Once decisions were challenged, the relationship between the parties disintegrated to such a degree that there were accusations of theft, embezzlement, diversion of business assets, and more. It was not long before there were active discussions and negotiations regarding a corporate divorce and the need for a business valuation. It is not unusual for attorneys to be involved at that point and, where there are attorneys, there is the likelihood of litigation.
What started out well (a new business), would not end as satisfactorily! Litigation was initiated to resolve the civil fraud claims and the business valuation/buyout issue. The court authorized a forensic fraud examination, producing a 100+ page report, and appointed a panel of valuation experts designed to resolve such disputes, in accordance with the law of the state. The ensuing drama went on for over two years at a cost estimated in the hundreds of thousands of dollars.
We were one of the three appointed valuation experts. Because of the length and complexity of the fraud examination report, the court requested the panel to make a determination regarding the existence of fraud, its impact on the value of the business, and to provide a buyout value.
A difficulty in achieving the court’s request was whether the value could be determined if there was credible evidence of unreported (stolen) receipts and fraudulent (personal) expenses recorded in the financial statements of the business (i.e., the value would be impacted by such unreported fraud amounts).
Additionally, the valuation panel unanimously found the fraud report unreliable and completely speculative – in essence, unhelpful. Consequently, the panel conducted discovery and multiple interviews of the owners and management team. The panel discovered that the IRS and local government agencies had conducted comprehensive audits of the business corporate tax returns in the recent past and issued “no-change” audit letters. That seemed to be persuasive evidence that, at minimum, reported income and expenses were reasonably accurate. There was no better evidence produced one way or the other.
The business was valued based on the financial statements of the business. The court ruled that one of the shareholders could be bought out at the amount derived from the valuation panel’s conclusion, or the business would be ordered sold or liquidated. It was an outcome that could not possibly have been anticipated when two friends decided to start a business together and “share” all the control of the business. It is likely that neither party was happy with the result. Neither shareholder could have felt that they had any control of their destiny throughout this process. A lesson to be learned – think long and hard before entering a 50/50 partnership!