Musings on Business Divorce

Simply put, business divorce is when one or more business owners no longer want to continue with the business. The process can be nastier than a matrimonial divorce, with a drawn-out and expensive litigated dispute.

I have recently seen a sharp spike in business divorce cases. The recent spike may be caused by business owners that paused doing what they would have otherwise done during the pandemic. I also believe many businesses and business owners are flush with cash or access to capital. Improving and stable economic conditions are offering a unique opportunity to pursue entrepreneurial goals.

A thoughtful operating agreement that allows for business partners to exit gracefully often makes the process easier. The below focuses on LLC divorces because most small businesses are set up as LLCs. Limited partnership (LP) business divorces are very similar, but there are some different steps for corporate divorces.

Demand for Records under Wis. Stat. 183.0405

Under Wis. Stat. 183, any member of an LLC can demand extensive records at any time, even before a dispute turns into a lawsuit. A member with 1% or 99% interest have the same rights to records under this statute. This request is most likely directed at the registered agent, who is also most likely to be the majority owner. Business records that must be produced include:

  • A list of every member and their membership interests.
  • The Articles of Organization.
  • Four (4) years of tax returns.
  • The Operating Agreement.
  • The value of each member’s contribution, when any additional contributions were made, and any documents that affect dissolution.
  • Any other writing as required by an operating agreement.

All LLC members, particularly controlling members or members that primarily handle the financial aspects of the company, should consider the story these documents may tell. If the records are organized, easy to access and read, and demonstrate sound financial decision-making and management decisions, this business divorce is likely to run much more smoothly. If not, the owners may be in for a messy business divorce.

It’s About the Benjamins

An exiting business owner ultimately wants to be paid and move on to other endeavors. Wisconsin’s LLC law provides that a dissociating member is entitled to “complete redemption of the fair value” of their ownership interest. This statutory language is broad and no further details regarding valuation are provided. Very few Wisconsin cases elaborate on this statutory language, but it appears intended to be expansive and broad.

Prudent LLC owners may want to contract out of this statutory language with a carefully-tailored operating agreement. Some businesses may want to restrict member transfer rights and make distribution rights something less than “complete” and “fair” value. Well-drafted transfer clauses will make valuation clearer and may be tailored such that it is less likely that the exiting business owner will cripple the company or hold it up in expensive litigation over valuation. LLC members need not fight over how the business appraisal process should work because they can agree ahead of time in the operating agreement.

Defending a Minority Owner Exit

If the remaining member or members do not want to pay the exiting minority owner “complete” and “fair” value for the business, they may try to ignore the demand and continue business operations. The exiting member will then likely threaten or file a lawsuit for judicial dissolution or ask a court to determine and award fair value. If the business is worth zero dollars without the exiting member, then the business likely should be closed and the owners should consider moving on. Nobody needs to fight over the value of a worthless business. However, if the business is valuable as an ongoing concern, the remaining owner or owners should negotiate a value.

Litigating a value will likely requiring dueling experts and may require extensive discovery. Cost likely to be incurred to determine “complete” and “fair” value will likely include an expert in business valuations, attorneys’ fees, and time. Defending a minority owner’s arguments regarding valuation will likely require the same. This can push smaller businesses to act reasonably and settle quickly. However, when the amount in dispute is large, these expenses may be worth it for the exiting member.

In business divorce cases, all should consider mediation as a viable path to amicable resolution.

Fraud and Improper Self-Dealing in Business Divorce

Business owners may be headed to litigation when the demand for records does not show sound management. Wisconsin LLC statutes and Wisconsin common law provide that LLC members must maintain a duty of loyalty and of good faith and fair dealing to the LLC. Individual members of an LLC may sue other LLC members for harm to the LLC. These rules can be modified in an operating agreement. Prudent LLC members may have other business interests that may appear conflicting with the LLC. They would do well to limit their duty of good faith and fair dealing and take steps on the front end to avoid these claims.

Additional Business Divorce Tort Options

Several business torts come into play in business divorce cases:

Statutory Fraud: Wis. Stat. 100.18 provides a private statutory cause of action for fraud in business transactions, and likely applies to some business divorce cases. It provides broad protections to business activities that cause harm when obtained by untrue, deceptive, or misleading representations.

Common Law Intentional Misrepresentation: The elements of intentional misrepresentation are: (1) the defendant made a representation of fact; (2) the representation was untrue; (3) the defendant made the representation either knowing that it was untrue, or recklessly not caring whether it was true or false; (4) the defendant made the representation with the intent to deceive the plaintiff in order to induce the plaintiff to act to plaintiff’s pecuniary damage; and (5) the plaintiff believed that the representation was true and relied on it. The plaintiff’s reliance on the representation must be justifiable.

Common Law Strict Responsibility Misrepresentation: This claim is like Intentional Misrepresentation, but the plaintiff must show the defendant had an economic interest in the fraudulent transaction – likely met in business divorce cases.

Common Law Negligent Misrepresentation: This claim may be easier to prove than the above because the plaintiff is not required to prove the defendant was ‘intentional’ in making the wrongful representation, but instead merely acted ‘negligently’.

Civil Theft: This comes into play when a member is stealing from the LLC. If the behavior sounds like criminal theft, the civil theft statute allows for a civil action to collect damages from that theft. The plaintiff is essentially claiming the right to monetary damages instead of a criminal conviction. The devastating impact of Civil Theft by Misappropriation is in damages. If a plaintiff proves a claim under Wis. Stat. 895.466 and 943.20, the plaintiff can collect the following:

  • Actual damages: most often the amount of money lost.
  • All costs of investigation and litigation reasonably incurred, including reasonable attorney’s fees.
  • Exemplary damages of not more than 3 times actual damages.

This is a non-exhaustive list, but suffice to say that Wisconsin statutes and common law provide many causes of action in tort for business divorce scenarios.

Avoid a Nasty Business Divorce with Sound Management and a Prudent Operating Agreement

Do not expect the same commitment from your spouse and your business partner.

Unlike matrimonial divorce, business partners do not promise to love, honor, and cherish each other in sickness and in health, till death. Their promise is far more limited. They will likely sell it before they die. LLC members are allowed to have other businesses. They agree to the partnership to make money and have a far more limited duty of loyalty and fair dealing. Your business relationship and your marriage do have some corollaries… but they are not the same.

Weekly date night may be the best way to avoid a matrimonial divorce. This advice is also helpful for businesses. Finances are the biggest stressor in a marriage and a business relationship. Be open and honest with your business partners about financials. Set regular meetings to discuss financials, and document those meetings. Pull your business P&Ls and review income and expenses during regular meetings. Discuss options for improvement. Document your review sessions and management decisions. These records will help avoid a nasty business divorce and demonstrate prudent business management. These prophylactic measures may also help your business be successful. Win-win!

Every business owner should plan for an exit. Hopefully, this happens after decades and bags of money. If you are leaving a business, I would be happy to discuss your options.

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