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How to Properly Formalize Business with Partner to Avoid Conflicts

02 November 2020
Kirill Shcherbakov
Partner
Corporate Practice
Litigation & Arbitration. Bankruptcy
In the modern world, cooperation between entities holding different assets, connections and skills is the key to successful business development.

Quite often there is a situation in which a specialist in a particular field has excellent business ideas and experience, but does not have sufficient assets and funds for development. In turn, people with capital are not always ready to independently engage in the creation and development of certain areas of commercial activity. Quite often, a holder of intellectual rights and goodwill can become a partner in the business. This is the case, for example, when a new partner joins a company that experiences difficulties but is well-known and brings anchor clients, assets, capital, etc. to it.
In Russian reality, it is not uncommon when a person who is able to ensure the smooth operation of the company in terms of administrative settlement of arising issues, obtaining the necessary licenses or benefits becomes a partner of an existing business.
All these prerequisites for joint activities lead to the need to formalise relations in the format of a company or group of companies of various forms of incorporation. There can be many options in this case, depending on the specific situation and objectives, as well as the scope of functions assigned to partners.

Limited Liability Company (LLC). Quite often, a limited liability company with agreed distribution of membership interest is used as a form of cooperation. Members conclude a separate agreement in which, in accordance with the Limited Liability Companies Law (Article 8), they undertake to exercise their rights in a certain way and/or avoid (refuse) exercising these rights, including to vote in a certain way at the general meeting of the company's members, agree on the voting option with other members, sell membership interest or part of interest at a price determined by such agreement and/or in the event of certain circumstances, or abstain (refuse) from the alienation of membership interest or part of interest until certain circumstances occur, as well as to carry out other actions related to the management of the company, incorporation, operation, reorganization and liquidation of the company.

Joint-Stock Company (JSC). To solve a number of problems, the structure of a joint-stock company is used which has its own specifics and tools for the relationship of participants called "shareholders". The register of shareholders is not accessible to third parties and can be transferred for keeping to a specialised registrar, which reduces the risks associated with the abuse of shares and the rights of business partners. Shareholders also have the right to conclude a shareholders' agreement, which is similar in nature to the Agreement of LLC Members and to stipulate their relations in an official document.
If partners ignore this option, then if there is a conflict in the future, this can lead to numerous mutual grievances and lawsuits.

The factor of misunderstanding and different assessment of each other's contribution to joint activities is often underestimated. This psychological phenomenon is expressed in the fact that a partner who has been engaged in business development for a long time begins to perceive themselves as an integral and most important part of it. At the same time, they forget that the investor who has invested their money and connections in the business initially considers themselves its owner. The investor may underestimate the fact that without the development, ideas and experience of the managing partner, the invested assets are not a business and cannot grow by themselves, especially since all contacts with customers and suppliers are usually carried out by the managing partner. This hidden conflict can manifest itself when business begins to make a profit. In its extreme manifestation, it is expressed in serious and lengthy lawsuits, when each of the partners has the opportunity to cause huge damage to the joint business and demands an increase in their share.

To minimise the above-mentioned risks, partners should always understand what will be the role of each of them in the joint venture, which returns from businesses they expect for themselves in the long term (at least approximately) and what restrictions they may impose on each other to neutralize the possibility of abuse in the future. This does not mean that they do not trust each other, but the situations can be different. The partner's share may be foreclosed or it may be inherited, which means that the business itself may suffer. To ensure the stability of the company's operation, mutual restrictions on the rights and obligations of members/shareholders can be provided at the level of the constituent documents. In this case, it is very important to discuss this issue together with professional lawyers and properly formalise the agreements.

Choosing the right business partner is a complex and serious process. A positive and trustworthy person who is talented in certain areas may be completely unqualified and unable to engage in commercial activities. In turn, an experienced specialist in commercial affairs may behave in bad faith in business and reports to its partner. It is not uncommon for a partner to create parallel commercial structures after receiving investments for business development, and in the course of development, take away the most promising clients. This often happens when there is insufficient control on the part of other participants and poor quality audit in the course of activity.

In addition, personal qualities and habits of people cannot but affect the joint business. As much communication as possible between partners outside the business is extremely important to understand and avoid possible difficulties. Addictions to alcohol, gambling, political and religious beliefs, as well as life position and goals cannot but affect joint activities. The sooner these factors are known to business partners, the easier it will be to eliminate the risks of joint activities or to abandon it altogether.

As an example of a failed partnership, I can mention the case of a food production plant (from BBNP's practice). The investor purchased a semi-abandoned production complex, warehouses and transport. A friend of the investor who actually offered the investor to invest in food products was appointed the CEO (hereinafter referred to as the "director" or "managing partner") of the enterprise. The managing partner had the experience, clients, a team of specialists in the food trade and administrative resources in the region where the enterprise was acquired. He received a 1/3 share in the company and began to develop the business. After 5 years, the company grew from an abandoned production complex with several employees to a serious company with a hundred of employees and large turnover. The company's brand became recognisable. The director, putting this success to his only credit, demanded to change the terms of the partnership to 50/50 shared ownership or pay him a very substantial amount of remuneration.
The investor, assuming a financial return on his investments, did not agree with the requirements of the managing partner, realising that the director will not cancel the existing contracts himself, and the employees loyal to the investor have all the necessary skills and capabilities to maintain and develop the business even without the managing partner.
The conflict resulted in four years of litigation, searches at the enterprise, an open and subsequently closed criminal case against the investor, subsidiary liability of the managing partner for the company's losses and the sale of the managing partner's share to third parties at a significantly lower price than he initially expected. All participants in the corporate dispute suffered serious stress, losses and loss of goodwill, the company was subjected to numerous inspections, and some employees were dismissed or resigned voluntarily. If the partners had foreseen the consequences of business growth in advance, discussed the director's incentive program and buy out of shares when certain indicators are reached, concluded a shareholder agreement and paid more attention to internal control and audit, it would have been possible to avoid most of the mentioned consequences and resolve disputes amicably.

The conclusion is obvious. The correct solution to the problem is to prevent its occurrence. It is necessary to identify, speak out and formalise the intentions of partners when creating a joint business, as well as determine the most convenient corporate form for work and arrange everything properly. I always try to convey the main idea to future partners: imagine that you are "getting divorced" tomorrow, just take it as a given, no offence. And then I explain what risks each of them will face. Such a detailed explanation helps to develop the most reliable agreement for all partners and minimise the occurrence of conflict in the future.
Kirill Shcherbakov
Partner
Corporate Practice
Litigation & Arbitration. Bankruptcy
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