I recently represented a small business owner who was embroiled in a dispute with two co-owners.
The story went like this—three people decided to start a new business. One (my client) had significant assets but no cash, so my client pledged those assets (including a commercial building) to get start-up money. My client had no time to run the new business because they had a successful and busy business of their own. But my client had two friends who dreamed of being their own boss. They had enthusiasm and talked like they had the know-how. What they did not have is money. These two friends were willing to quit their jobs and operate this new venture. So the three of them went to a local lawyer and asked the lawyer to form a business entity. They decided to run this new operation as an LLC (limited liability company) and asked the lawyer to draft a “standard agreement.” My client never thought to retain an attorney. The three of them wanted to do this as cheaply as possible. To save money, my client even drafted the rental agreement for the commercial building, using a form he had found on the internet. My client filled out the form indicting that my client was the landlord, the two new partners were the tenants, and my client’s building was the location for their new venture.
The LLC was set up so that the three partners each had an equal interest. My client mortgaged assets to borrow start-up money which was transferred to the LLC. The two partners quit their jobs and became the managing partners and day-to-day workers. The two partners handled the sales, hired the help, ran the books, ordered product, paid the expenses, and made the deposits. My client merely checked in from time to time for updates.
My client’s two partners hired employees and paid everyone (including themselves) out of the business account (consisting of the money borrowed by my client). They were spending more than they were making. The two managing partners were less than forthcoming about the success of the business, and my client was denied access to the records. Heated arguments erupted. That’s when my client became my client.
This kind of thing can’t be sorted out with one phone call. I had to see my client in person and read the relevant documents. So we met at my office and I read the LLC Operating Agreement and the rental agreement.
My client was shocked. The LLC agreement gave my client’s two partners (together) majority ownership and placed them in charge of day-to-day operations. My client could not fire them, could not liquidate the business, and could not change the accounts without their consent (or a court order). My client was stuck for the loan at the bank, but the managing partners were not. The two partners individually (and not the LLC) were the renters of his building. But since the rental agreement gave them exclusive possession, in the meantime there was nothing my client could do about it.
Sadly, the business went south, and more heated words were exchanged. The two managing partners kicked my client out of my client’s building. (After all, they were the sole renters.) The rental agreement had a term of six months, and the two managing partners had the LLC stop making the payments to my client. They could come and go as they pleased in his building until my client was successful at court in an eviction action for non-payment (which took over three months). Once the bank account was pretty much dry, the bills were piling up, and the rental term expired, my client’s partners quit as employees (but would not surrender their ownership interest in the LLC). My client was left to try to pick up the pieces of a failed business all alone while also working full time running their existing business. My client was completely overwhelmed and totally devastated.
To make matters even worse, my client’s partners then went to work as employees for a competing business in the same town. Ironically, the new business was owned by one or more of their former employees from the LLC (the ones hired by my client’s two partners). And the new business was courting some of the same customers and getting some of the same sales as the old business.
HOW COULD THIS HAVE BEEN PREVENTED?
If my client had come to me before starting the business, I would have repeated the golden rule of business—“he who has the gold makes the rules.” The LLC would have been set up to make my client the majority owner and make my client the managing agent for the operation. My client would have controlled the books and records. My client would have had final say in hiring and firing. The rental agreement would have been made between my client and the LLC with a month-to-month lease. Ceasing operations as a business would have terminated the lease immediately. The LLC agreement would have contained a mandatory buy/sell clause so that when triggering events occurred, the two managing partners would be forced to surrender their interest in the LLC.
If my client had come to me before starting the business, the partners and all employees would have been required to sign confidentiality agreements and non-compete agreements, which would have stopped them from setting up shop near the LLC to compete directly against it, and further stopped the former employees from using the information they obtained while at the LLC to compete against the LLC.
So here’s the lesson—first, if you buy a form, you get a form. When the three of them went to a lawyer to set-up the LLC, they just wanted it done quickly and inexpensively. They just wanted “a standard agreement.” And when they needed a rental agreement for my client’s building, my client merely looked on the internet for a form.
Second, only your own lawyer can protect your own interests. When the three partners together went to a lawyer to set up the LLC, that lawyer owed a duty to the new LLC, not to my specific client. That lawyer merely did what he or she was asked to do. Their lawyer didn’t represent any of them. Their lawyer represented their common business entity.
To start this business, my client pledged over $250,000 in assets. But my client didn’t think to spend a couple thousand dollars up front to have someone represent my client’s interests. And now my client is paying thousands of dollars trying to get out of a bad deal and salvage what’s left of a failed business.
A form cannot protect your interests. Only a lawyer can do that.