Ten Legal Mistakes Made by Start-Ups: Bringing in a Partner Without a Proper Agreement (#8)

Often start-ups are so excited about bringing in a partner who can offer financing, desperately needed services, or play an advisory role/provide professional advice that the start-up brushes aside the need for a proper agreement detailing the rights and obligations of the new partner.

Myth #8:  "This is a start-up and we should be happy to have this new partner so let's not worry scare the partner off by demanding a formal agreement."  

If you are involved with a start-up you certainly understand the pressure to attract partners who can offer financing, professional services, or even play an advisory role.   All too often, however, this anxious desire to attract such a partner will lead founders to opt to put aside the need to document the rights and obligations of the partner; it may be because of the desire to avoid additional legal costs or simply feeling that asking the potential partner to sign an agreement will scare the partner off.  So instead the founder decides to have a simple handshake and issue the new partner shares or membership interests representing a percentage in the business.  In no uncertain terms, this is a serious mistake for a number of reasons, including the following:

    1.  If this is an LLC, do you have an Operating Agreement?  If this is a corporation, do you have detailed by laws/shareholder agreement?  If this is a partnership, do you have a partnership agreement?  If the answer is no, then the new partner has financial and voting interests based on the interests granted in the entity; and any rights and obligations are otherwise governed by the relative state LLC, Corporate or Partnership law.  Do you know what the governing law says as far as the financial and management rights of members (LLC)/shareholders (corporation)/partners (partnership)?  If not, you may be very surprised later if a dispute arises, at which point it will be too late. 

  2.  What if the new partner fails to do what was promised, dies or becomes disabled?  You could have avoided this issue by having the interests vest over time (see http://mybizlawyer.blogspot.com/2011/10/ten-legal-mistakes-made-by-start-ups_28.html) and/or giving the entity and other partners a buyout right (see http://mybizlawyer.blogspot.com/2011/10/shareholder-agreements-define-buyout.html).  If you do not attend to this issue, you could be stuck with a non-performing partner and perhaps hanging your hopes on the expensive and time consuming process of proving an oral agreement in court.

  3.  The partner decides to sell or transfer its interests to a third party you don't know or don't like (or both).  Can the partner do this?  It depends what the governing law says, but if you had a clear statement of the rights of the partners and a right of first refusal there would be no issue.

  4.  The new partner just signed a contract binding the entity, one which you would not have approved.  In New York, an LLC is deemed to be member-managed unless the Operating Agreement states otherwise, and a s a result each member has the authority to bind the entity.  Solution, an Operating Agreement setting forth that the entity is manger-managed, naming the manager, and thereby removing the authority the new member to bind the entity.  (See http://mybizlawyer.blogspot.com/2011/09/management-of-llc-member-or-manager.html).  Also, LLC and Corporations (but not SCorps) are very flexible structures allowing for the creation of different classes of partners, and therefore you can create a class that has only financial rights and no management/voting rights.

  5.  You just learned the new partner is starting a competing business or offering services to a competitor and is also trying to solicit your employees, customers, and business partners.  If the partner is using trade secrets you still can take seek legal recourse, but again proving the claim is costly and regardless does not address some of the other concerns, like solicitation of your employees.  While enforcing a non-competition agreement can be challenging and requires careful consideration before drafting, you should include confidentiality and non-solicitation provisions in the operating agreement/shareholder agreement/partnership agreement.

  6.  The partner developed services, an application or created products that include certain intellectual property rights and now claims ownership of those products/services or of the underlying intellectual property.  In fact, the partner is filing patent claims and then plans on licensing the rights to third parties.  You could have avoided any issue with an  invention agreement agreement assigning the rights to the inventions and intellectual property to the business.  (See  http://mybizlawyer.blogspot.com/2011/10/ten-legal-mistakes-made-by-start-ups_24.html).                      

  7.  You have a dispute with the new partner, who files a groundless lawsuit in Buffalo, and the other members and the business are located in Long Island.  You realize the added burden of litigating a dispute in a court hundreds of miles from where the business is based, and while the your  lawyer explains there may be grounds for a motion arguing Buffalo is not a convenient forum for the dispute, the motion will create additional litigation costs.  You could have avoided this issue with a venue clause stating all disputes are to be filed in Nassau County, for example.  It also may have been beneficial to include a provision awarding attorney fees to the prevailing party, giving the partner pause before filing baseless claims.  

While the above is in some ways a recap of prior issues that have been discussed in this blog, the take away here should be that even a start-up has a right to demand a new partner sign an agreement clearly delineating the rights and obligations of the members of the entity.  If the new partner refuses or wants you to believe a handshake is enough, you should be very suspicious.  There is simply no substitute for a well-drafted agreement to avoid the myriad legal issues that can arise between business partners. 

Disclaimer:  The above is for discussion purposes only and does not constitute legal advice nor create any attorney-client relationship.  There is no substitute for legal advice from an experienced business/corporate lawyer.