The 50-50 Equity Split(up)
December 2, 2015 | By Rad Wood
My parents are starting a business together. See, my mom runs an organic, all natural beauty salon in Upstate New York. Part of the business that she has developed over the years is using henna as an eco-friendly alternative to chemical hair dyes. She’s good at it. So she decided to start importing henna from India. Her client list continued to grow. She wrote a book on the process; did I mention she was good at it? And now she is in the early stages of create her own line of henna hair dyes. It’s exciting. But where my mom is great with hair and henna and the ideas, she sometimes isn’t the best with record books and numbers and all that boring stuff. So that’s where my dad comes into the picture. He’s good with numbers; he likes to balance budgets and file taxes and figure out if the dollars and cents make sense. Knowing their own strengths and weaknesses, my parents decided to start this new branch of my mom’s business together. As a result, they called their lawyer son to discuss entity formation, contracts and next steps.
While I was excited for their business together, I ignored their many questions and asked one of my own—how do you plan to split the company? Equally? Without hesitation they said yes, 50-50. Now my parents have been married for 38 years and have been together for over 44, so they’ve been through their share of disputes, but I had to push back. I warned them of the dangers of splitting a company’s ownership and voting rights in half—how will you resolve a disagreement? What happens if you each want to take the company in a different direction? They were a bit taken aback by their son giving them advice about how to resolve disagreements, but I had to warn them—when a big disagreement occurs in a 50-50 split it results in a stalemate that often ends with the dissolution or termination of the company.
Now of course my parents have weathered many a storm together and are likely uniquely qualified to handle a company that is split 50-50 (then again no need risking nearly 40 years of marriage on a startup idea that could create business disputes that they have yet to encounter together), but for the average business team a 50-50 split is one of the most common and most destructive mistakes I encounter during my practice. Usually by the time I am dealing with a 50-50 split the good feelings and team work that created the even distribution have faded, replaced by acrimony, incrimination and a long history of unhealthy communication. That is the reality of business relationships, however. We start the relationship because things are going well. But try as we may, we cannot predict the future and what started off great can, and sometimes does, end poorly.
That is why I counsel all of my clients against a 50-50 split, or at least spending the time and money to draft and execute a company agreement or shareholders agreement that addresses the risks of such a division of equity through dispute resolution clauses, buy-sell provisions, put and call option language as well as proper restrictions on transfers of equity and default and expulsion standards that allow fellow equity holders to hold one another accountable.
It’s true that a company agreement tailored to your business creates an upfront cost. And it is equally true that when you and your 50-50 partner are in the honeymoon stage of the startup life it may seem advantageous to save money on that upfront cost and instead use Rocket Lawyer or Legal Zoom to create a generic company agreement for you. I can tell you this is a mistake. Every person I have dealt with that has found him or herself in the midst of a company-crushing 50-50 dispute would gladly have paid several hundred dollars more up front to save the thousands of dollars in legal fees it usually costs to handle the breakup. And the customized clauses that are needed to deal with 50-50 splits are easily drafted and make you better partners; they facilitate the conversation up front so that when a dispute arises the parties do not view it as the end of the world. You’ve already dealt with this possibility beforehand, you both knew a dispute would arise and you had the foresight to deal with it in advance.
Now while I will help facilitate 50-50 splits if my clients cannot be convinced otherwise, in the end I still prefer ownership breakdowns that can never end in a stalemate. And that’s exactly what I did with my parents. Mom and Dad still have equal amounts of equity in the Company, but now there’s an investor who once told them it was a bad idea to split the company 50-50, who owns just enough of the family company to break any unwanted tie votes. Speaking of which, if you’re ever in need of an all-natural hair dye, I know just the company you should purchase from. And I promise I can get you a good deal on the henna!