The Dreaded Tangle of a Business Decision Deadlock

Posted on Sep 7, 2012

Imagine the following scenario: You and a childhood friend reconnect over lunch. Both of you have been looking for a new business opportunity for some time. You come up with a great new idea and a strategy for putting that idea into operation. Each of you wants to put the same amount of seed money into the business, and both of you will take an active role in managing operations. Profits and losses will be split 50/50, and both owners will have to agree on all major decisions.

One of the issues that arises when representing owners in the formation of a business entity that will be structured to have equal ownership interests or management rights is how the decision makers will resolve deadlocks over business decisions. A deadlock can be crippling to business operations and cause the business value to fall while the decision makers disagree over the direction in which the business will proceed. No one wants to address this issue, since the owners are excited about starting a new business and see nothing but prosperity in their future, but deciding how to resolve deadlocks at the outset will almost always make it easier to handle them down the road. Addressing deadlocks created by equal ownership interests and management rights at the entity formation stage is one of a number of best practices we recommend considering when forming a business.

Here are three possible approaches, and some of the pros and cons:

1. No Resolution – The owners may identify certain decisions that should not be made unless the owners are able to agree on them and that should not provide for a means of resolving a failure to agree. For these decisions, the result of a deadlock is that the proposed course of action will not occur. Typically, these are fundamental business decisions, such as the decision to sell the business, which will not frustrate the purpose of the business to such a degree as to make it inoperable should they fail to occur. The main advantage to this approach is that it forces the owners to work together to reach a solution if they want to make the decision. A disadvantage is that, unless the owners can agree, the decision cannot be made.

2. Establish an Exit Strategy or Wind up the Company – Another approach to resolving deadlocks is to require or allow the non-consenting owner to leave the business. Alternatively, the owners may want to require that the business be wound up. Some tools for allowing an owner to exit the company after a deadlock include buy/sell rights, put options and call options. A description of these tools and the issues presented in using them is a topic worthy of independent discussion and beyond the scope of this article. One advantage to using exit strategies to resolve deadlocks is that it allows the remaining owner to continue the business operations in the way he or she sees fit while providing the non-consenting owner with a means of exiting the business. One disadvantage to this approach is the potential for abuse by an owner using this approach as a basis for staking out a position and being unwilling to negotiate rather than trying to work towards a mutually agreeable solution.

3. Refer the Decision to a Third Party – A third approach to resolving deadlocks is to refer the decision to a third party decision maker such as a trusted business advisor or mediator. One advantage to this approach is that a decision will be made, whatever it may be. The primary disadvantage to this approach is that the person making the decision may not have a complete understanding of all of the considerations at play and has no stake in the outcome.

These three approaches are not meant to be an exhaustive list and, as you can probably see, there is no one “right” answer for resolving deadlocks. There are also a number of additional issues that must be addressed in making a decision as to how to resolve different types of deadlocks and in structuring the resolution mechanism, which are not discussed in this article and often will be unique to each particular client and business.

Our goal in advising clients on how to approach deadlock situations is to provide sufficient information to help our clients think through the available alternatives specific to their unique situation and to make an informed decision as to which approach or approaches will best serve their interests and risk tolerance given the circumstances. If you would like more information on this topic, please contact Allen Bertin, a lawyer in our firm’s corporate department.