“Sure, 50\50 ownership is fine” the potential clients said to me as they looked across my desk. “We haven’t really talked about it, but I guess it’s fair. Do you think that’s best?”
Entrepreneurship is my jam – I love it! I have met with many nascent entrepreneurs – all with various legal and business related questions, but, on the subject of how equity should be split, their questions usually take the form of the example above. This post deals with ownership of equity in a new business, and specifically, how some equity decisions will lead to deadlock and therefore, require carefully planned mechanisms to defeat it and bring about a resolution.
What is Deadlock?
In the context of a business, “Deadlock” means that a majority (i.e. 51%) of those shareholders with decision making power cannot come to an agreement in regard to a choice that needs to be made for the Company. This kind of situation doesn’t come up all that often in the totality of business disputes, but, in the context of a new company, especially a closely held company with few shareholders, the likelihood is pretty high.
How and Why Does Deadlock Occur?
Deadlock occurs when the equity in a Company is split so that no shareholder has majority control (51%) and therefore, coalitions between them (i.e. agreement) are required to make a decision. If there is no agreement, there is no decision, and therefore, deadlock. But why deadlock occurs is the important question.
In my experience with new entrepreneurs, the biggest reason deadlock occurs is because the shareholders in the Company fail to discuss their responsibilities and expectations. Those conversations can be uncomfortable to have with your friends, so many people avoid the discussion all together. Even if its clear one Founder will do the majority of the work, rather than discuss, most Founders agree “just to split it down the middle.” Meaning, everyone has to agree, and nobody is clear about their roles – not a recipe for success in friendship or in business.
How To Avoid Deadlock
There are various solutions to avoiding and\or dealing with deadlock – here are a few to think about:
- Make someone the majority shareholder. If someone owns 51% of the Company, deadlock cannot occur (unless a Super Majority or Unanimous consent is needed for some actions of the Company.).
- Designate a Manager – To reduce deadlock, and to make decision making easier, the Company might consider appointing a “Manager” who is tasked with day to day decision making and has the power to do so. If only larger Company decisions are subject to Majority Consent (rather than ALL decisions), the likelihood of deadlock is reduced.
- Create A Deadlock Busing Process – Maybe 50\50 ownership and not designating a Manager are right for your Company – if that’s the case, you should discuss what will happen in the event of (the inevitable) deadlock. The process can be as complicated or as simple as you wish. Sometimes, clients want to appoint a disinterested third person (like an accountant) to make the final decision. Sometimes, clients are happy with a coin flip, Rock – Paper – Scissors, or best of three Candy Land (my personal favorite – because Candy Land is so painful when you’re not 6 years old that most people will just decide rather than play).
- DISCUSS, DISCUSS, DISCUSS – The most important aspect of avoiding deadlock is TALKING about it, discussing what everyone’s roles and expectations are and realizing – early on – that disagreements will occur. When those disagreements happen, how will they be resolved – and by whom?
Have these discussions early and often because the Company’s future depends on it.