How to Regulate Relations Between Business Partners

Most business partners first agree on ownership percentages. A significantly smaller number agree on what those percentages mean when one partner works more, the other invests extra money, and neither wants to compromise when making an important decision.

At the beginning of a joint venture, there is usually trust. Partners are friends, relatives, colleagues or long-term associates. They have a business idea, an initial plan and an expectation that they will solve problems by agreement.

Serious disagreements usually do not arise when the business is small. They arise when the business starts to grow, when additional investment is needed, when the contributions are no longer equal, when one partner wants the payment of profits, and the other the further development of the company, or when someone decides to leave the business.

The dispute then does not necessarily arise because someone had bad intentions from the beginning. It often arises because the relations between partners in business were not regulated precisely enough while the relations were still good.

A good contract cannot prevent every disagreement. It can, however, prevent it from turning into a business blockade, a decline in the value of the company or a long-term dispute.

Why a verbal agreement between partners is not enough

Partners often agree on who owns 50, 60 or 70 percent of the company, but do not clarify what the ownership percentage really means.

The share percentage alone does not answer the questions of who runs the day-to-day business, what decisions a partner can make independently, how much each partner is required to work, how fees are determined, what happens when additional investment is needed and how a partner can leave the company.

An informal arrangement can work as long as the partners have the same interests. When their interests diverge, each often remembers the deal in a way that suits their current position.

A contract between business partners is therefore not a substitute for trust. Its purpose is to turn common expectations into clear and demonstrable rules.

The articles of association and the members’ agreement are not the same document

When founding a limited liability company it is especially important to distinguish the articles of association from the contract of the company members.

What is regulated by the articles of association

The articles of association is the basic corporate document of a company. It regulates the members of the company, their roles and shares, basic capital, management and other issues important for the organization and operation of the company.

It can regulate the voting method, the required majority, the transfer of shares, the right of pre-emption, the consent to the transfer of shares and the competences of the company’s bodies.

The rules that should produce an effect within the company must be harmonized with the articles of association, decisions of the company’s bodies and compulsory regulations.

What is the purpose of the contract of members of the company

According to the Law on Business Companies, a member of the company can enter into a contract with one or more members of the same company in writing and regulate matters important for their mutual relations in connection with the company.

In a limited liability company, this document is called the members’ agreement.

The contract of the members produces an effect between the members who concluded it. Therefore, a rule introduced only in that contract does not automatically change the articles of association nor does it necessarily produce the desired corporate effect towards the company, its bodies or other persons.

The members’ contract can be regulated in more detail:

• division of work between partners
• obligations of their personal engagement
• additional financing
• profit distribution
• way of voting on important issues
• confidentiality
• dating partner
• determination of share value
• resolving the business blockade

The articles of association and the contract of members should therefore not be viewed as alternative documents. They must be coordinated with each other.

Depending on the business model, an employment or other partner engagement agreement, a director’s agreement, a loan agreement, an intellectual property agreement, a confidentiality agreement, or an investor agreement may also be required.

Why Ownership Percentages Should Not Automatically Determine Powers

The question of who gets what percentage of the company should not be decided only by who first proposed the idea or who has better relations with whom.

It is necessary to consider:

• who invests money
• who brings in equipment or other property
• who provides clients and contacts
• who contributes knowledge, software, trademark or other intellectual property
• who will be engaged on a daily basis
• who takes the biggest business risk
• what happens if someone leaves the project soon

Equal shares can be justified when contributions, risks and future obligations are truly equal. However, a 50 to 50 ratio is not in itself the fairest solution.

Such a structure can lead to serious deadlock if each partner has equal voting power and there is no pre-defined way of resolving disagreements.

Ownership, management and operation are not the same

A partner can be a member of the company, a director and an employee at the same time, but his legal position on each of these bases is not the same.

Therefore, it is necessary to precisely determine:

• who runs the day-to-day affairs
• who is the director
• who represents society
• who approves payments
• who hires and fires
• who leads sales, finance, development or customer relations
• which decisions everyone can make independently
• which decisions require the consent of other partners

It is not enough to write that the partners will “jointly manage the business”. It is necessary to determine who is responsible for specific areas and what happens when the assumed obligations are not fulfilled.

Partners with equal ownership shares do not have to receive equal monthly fees if their actual work and responsibilities are not equal.

How to regulate decision-making

Regular operational decisions should not be made in the same way as decisions on large borrowing, entry of investors or sale of the company.

Partners can provide that certain decisions are taken independently, by simple majority, qualified majority or unanimously.

A special regime most often makes sense for decisions about:

• significant borrowing
• sale of important assets
• change activities
• admission of a new member
• entry of investors
• changes in the basic capital
• profit distribution
• sale of the company
• cessation of business

Too many decisions that require unanimity can completely block business. On the other hand, if the majority partner can independently decide on almost everything, the minority member may be left without real influence on the most important issues.

The goal is to find a balance between effective management and protection of all partners.

How to prevent business blockade

Business blockage occurs when the partners cannot make a decision without which the company cannot continue business normally.

It most often appears in companies with two partners who have equal shares or when a large number of decisions require unanimity.

The contract may provide for a procedure that is activated when the disagreement lasts longer than a certain period. It can include:

• a new round of negotiations
• meeting with the presence of a neutral advisor
• mediation
• referring a professional question to an independent person
• an offer by one partner to buy out the other’s share
• sale of shares or the entire company
• controlled cessation of business as a last resort

Models known as Russian roulette or Texas shoot-out clauses are also used in international corporate practice. These are not special institutes named by domestic law, but contractual mechanisms that must be adapted to Serbian law and the specific relationship.

They are not suitable for every business. If one partner is significantly stronger financially, the ability to quickly secure buyout money can put them in an advantageous position.

How to arrange additional investments

Initial capital is often not enough for business development.

Partners should therefore determine in advance:

• whether they have an obligation to additionally finance the company
• how much each partner should invest
• what happens if one partner does not have or does not want to invest money
• whether the additional investment changes the ownership percentages
• whether the funds are given as a loan
• when and under what conditions the loan is repaid

It is not the same whether a member increases his contribution, makes an additional payment or gives a loan to the company.

A member’s loan to the company creates a debt relationship and does not in itself increase the lender’s ownership percentage. A change in the ownership structure due to additional financing also does not occur automatically, but requires a pre-agreed and legally properly implemented mechanism.

That’s why it should be clearly determined whether the additional money represents a proprietary investment or the company’s obligation to return that amount.

Salary, compensation and profit sharing are not the same

It is necessary to distinguish:

• compensation for daily work
• remuneration to the director
• profit sharing
• loan repayment
• fee for use of equipment or intellectual property

Partners with equal ownership shares do not have to have equal monthly fees if they do not work the same or are not equally engaged.

At the same time, higher compensation for work does not automatically mean a higher ownership share.

Profits are not distributed as soon as the company generates income. Before deciding on distribution, it is necessary to consider the results of operations, existing obligations, legal restrictions and the need to retain funds for further development.

Therefore, partners should determine in advance who decides on the distribution of profits, under what conditions it is paid and how many funds remain in the business.

Who owns the brand, software, customer bases and other business assets

For many companies, the greatest value is not in fixed capital, but in:

• brand and trademark
• domain and website
• software and source code
• client bases
• design and author’s content
• business procedures
• accounts on digital platforms
• business knowledge and experience

A particular risk exists when a key asset is formally registered to one partner, even though it was developed or used by the company.

If the domain is registered in the partner’s private name, and the rights to the software and source code have never been transferred to the company, its exit may threaten the continuation of the business.

That is why it is necessary to determine what belongs to the partner, what is only given to the company for use, and what should be formally transferred to the company.

Non-competition and confidential information

It is necessary to distinguish between the legal obligations of persons who have special duties towards the company, the contractual prohibition of competition between partners and the prohibition of competition within the framework of the employment relationship.

Those regimes are not identical and should not be united by one general provision.

The contract between the partners may regulate in more detail:

• keeping trade secrets
• using the client base
• taking over employees
• contacting existing clients after exit
• starting a competing business
• duration of obligations after termination of partnership

The non-compete should be reasonable and precise. It is necessary to determine which jobs it covers, where it is valid, how long it lasts and which legitimate business interest it protects.

The goal should not be to completely prevent the ex-partner from working, but to protect the specific interests of society.

What if the partner stops contributing to the business

A member of the company does not automatically lose his share just because he has stopped working.

The contract should foresee what happens when the partner ceases to work actively, does not fulfill obligations, blocks decisions, uses the assets of the company in personal interest, takes over clients, starts a competing business, loses the necessary license, becomes permanently incapacitated or dies.

In international investment practice, the terms good leaver and bad leaver are often used.

The first indicates a partner who leaves for justified or pre-accepted reasons. The second refers to a partner whose departure is connected with a serious breach of obligations, fraud or competitive action.

These are not special legal institutes of Serbian law, but contractual categories, the application of which depends on precisely defined reasons, exit procedure and method of price calculation.

A possible decrease in the share price cannot be based only on the arbitrary assessment of other partners. Such a provision must be carefully formulated and harmonized with the relevant rules of company and obligation law.

How to arrange the departure of a partner from the company

An employment agreement is not complete if there is no exit agreement.

Need to edit:

• can the partner freely sell the share
• who has the right of first refusal
• whether the company’s consent is required
• to whom the share cannot be sold
• how the price is determined
• within which time the price is paid
• whether payment in installments is possible
• what happens in case of death of a member
• how to act when there is an offer to buy the entire company

The transfer of shares should be analyzed according to the applicable legal rules and the articles of association of the specific company, especially with regard to the right of pre-emption, the necessary consent and the procedure for offering shares. When a share is bought by a new partner or investor, an important step is the due diligence of the company or share.

In international business practice, both tag-along and drag-along rights are often contracted.

Tag-along protects the minority member by allowing him to join the sale of the majority member and sell his share to the same buyer under suitable terms.

Drag-along enables the majority member to, under predetermined conditions, demand that the minority member also participate in the sale of the company.

It is not enough just to list these mechanisms by name. It is necessary to regulate the price, deadlines, notification, obligations towards the customer and partner’s responsibility for statements and guarantees given in the sales process.

How the share value is determined

The wording that the partner is entitled to the “market value of the share” is often not precise enough.

It is necessary to determine:

• who assesses the value
• according to which methodology
• on what date
• based on which financial data
• how debts are taken into account
• whether the brand, clients and intellectual property are valued
• who pays the assessment
• what happens if there is a dispute about the appraiser’s findings

The value can be determined according to the agreed formula, the assessment of an independent expert, book value, income, profit or a combination of several methods.

Book value may be inadequate in a firm whose main value lies in brand, technology or customer contracts. On the other hand, an estimate based on future profits may depend on uncertain assumptions.

Therefore, the assessment method should be adapted to the specific business model.

The responsibility of a member and a director is not the same

A member of a limited liability company is generally not liable for the company’s obligations just because he owns a share.

This does not mean that he is protected from liability for his own illegal conduct or violation of his obligations as a director, representative or person with special duties towards the company.

Member responsibility, director responsibility, conflict of interest, dealings with related parties, use of company property, misappropriation of business opportunities and abuse of the company’s legal personality should be distinguished.

Limited liability is not a license to use company property as personal property.

The contract between the partners cannot exclude the application of mandatory legal rules, but it can more precisely regulate internal obligations, the method of approving certain jobs and the consequences of violating the agreed rules.

Court, mediation or arbitration

Not every dispute needs to be brought before the court immediately.

The contract may foresee several successive steps:

• direct negotiation of partners
• a mandatory meeting within a certain period
• involving a neutral advisor
• mediation
• expert determination of value or other disputed issue
• arbitration or court proceedings

Arbitration can be suitable when confidentiality, the choice of an arbitrator with special expertise or the existence of an international element are important to the partners. The basic rules on contracting and conducting arbitration are governed by the Law on Arbitration.

However, arbitration is not automatically the best solution. It can be expensive for disputes of lesser value, while the possibilities of contesting the arbitration decision are more limited than in regular court proceedings.

The choice should be adapted to the value of the dispute, the number of partners, the type of business, the need for confidentiality and the possibility of executing the decision.

The most common mistakes of business partners

In practice, the following mistakes are most often repeated:

• important agreements remain verbal
• only ownership percentages are regulated
• a ratio of 50 to 50 without an anti-blocking mechanism is selected
• ownership is equated with employment
• it is not determined who makes which decisions
• additional investments remain unregulated
• it is not clear who owns the intellectual property
• there is no profit sharing policy
• no departure of partners is foreseen
• the share valuation method is not defined
• the contract of members is not harmonized with the articles of association
• the death, illness or long-term disability of the partner is not covered
• a generic contract is used without adaptation to the specific business

The biggest mistake is the belief that a possible conflict should not be discussed while relations are good.

That’s when it’s easiest to reach a fair deal.

Control questions for business partners

Before starting or continuing a joint business, partners should answer the following questions:

Who has what ownership stake and why?

What does each partner invest and how much is he required to be involved?

Who runs the day-to-day operations?

What decisions can everyone make independently?

Which decisions require the consent of all partners?

How is additional funding provided?

How are fees determined and profits distributed?

Who owns the brand, software and customer base?

How is a business blockade resolved?

How can a partner leave the firm?

How is the value of his share determined?

What happens in case of death or permanent incapacity of the partner?

If the partners do not have clear answers to these questions, their relationship is probably not regulated enough.

When is the right time for a contract between partners

The best time is before the foundation of the company or before the first serious investment.

However, relationships can be adjusted later, in particular:

• before the investor’s entry
• before accepting a new member
• before significant borrowing
• before more business growth
• before the change of ownership or management structure
• when the partner’s obligations have changed
• when the first serious disagreements appeared

The members’ agreement is not a document that should be signed once and put away forever.

As the value of the company, the number of employees, the sources of financing and the roles of the partners change, it is necessary to check whether the existing rules still correspond to the actual business relationship.

Conclusion

Partners can successfully run a business for years and make most decisions by agreement. However, legal documents are not prepared only for a period in which everyone thinks the same.

They are prepared for the moment when one partner wants additional investment, another wants a distribution of profit, a third wants to leave the company, and none believes that they should give way.

Quality arranged relations between partners in business can reduce the risk of disputes, speed up decision-making, protect the value of the company and enable a controlled exit of partners.

A contract is not a sign that there is no trust. It is a way for trust to not rely solely on memory, goodwill and the assumption that circumstances will forever remain the same.

The specific solution depends on the legal form of the company, the content of the articles of association, the ownership structure, the method of financing, the tax consequences and the business goals of the partners.

Frequently asked questions

Is an agreement between the partners required if there is a memorandum of association?

It is not always mandatory, but it is often very useful. The articles of incorporation govern basic corporate matters, while the members’ agreement may regulate in more detail work duties, financing, exit, share valuation and blocking resolution.

Can partners have equal ownership shares?

They can, but the 50 to 50 ratio requires a carefully arranged way of making decisions and resolving situations where the partners cannot reach an agreement.

Can one partner sell his share without the consent of the other?

The answer depends on the applicable legal rules, articles of incorporation and existing contracts. In particular, the right of first refusal, the need for consent and the agreed transfer procedure should be checked.

What happens if one partner no longer works in the company?

Cessation of work does not automatically mean cessation of ownership. The consequences depend on the contractual obligations, the position of the partner and the existence of grounds for transfer, withdrawal or other legally permitted solution.

How is the price of the exiting partner’s share determined?

The price can be determined by an agreed formula or by an independent expert’s assessment. It is necessary to determine the method, date of assessment, relevant financial data and procedure in case of disagreement.

Is arbitration better than court?

Not in any case. It may offer confidentiality and the choice of an expert arbitrator, but may be more expensive and provide more limited opportunities to challenge the decision.

Legal support in regulating relations between partners

If the articles of association determines ownership percentages, but does not give a clear answer to who decides, who makes additional investments, how the profit is distributed and how the partner leaves the company, the business relationship is probably not regulated enough.

JP Law provides legal support to founders, members of companies and investors through:

• analysis of existing relationships and documentation
• preparation and amendment of the articles of association
• preparation of members’ contracts
• arrangement of ownership and management rights
• defining additional financing
• development of share transfer and redemption mechanisms
• legal arrangement of exit of partners
• support in negotiations and resolution of existing disagreements

The best time to fix relationships between partners is before different expectations turn into a business and legal problem.