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Advice

Friends and families in business - what happens when familiarity breeds contempt

Those going into business together shouldn’t rely on family bonds or friendship as a stable platform on which to build their business.

Introduction

Disputes frequently arise in businesses which are jointly owned by friends and family, with difficulties arising later in the life of the business because essential formalities are overlooked at the outset of the relationship. 

Friend and family go into business

Many owner-managed businesses, perhaps even most, are founded by friends and family. Brothers, sisters, parents, school or college friends with a bright idea and the desire to make money on their own terms, as masters of their own business. What could be better?  

The seeds of future disputes, however, are often sown right at the outset, and that is not because of anything that the parties do at this initial stage – quite the opposite. It is what the parties don’t do at this stage, as they set out on their new business together, that gives rise to future problems. All too often essential formalities are ignored – it seems unthinkable that those involved could ever fall out. 

This is a very commonplace scenario. Usually, it’s only those who have previous business experience who take the time to properly organise the structure of their business before they set off. In the heat of the moment the parties forget that, at a future date, if the business goes well, their business could become extremely valuable. Provided relations between the parties stay good, that’s not a problem.  But, all too often, after the parties have worked together for several years and cracks begin to show in their relationship, questions arise regarding who owns what, who should have control of the business and what mechanisms are in place for one or more of the parties to exit – and on what terms. 

The default position

Most new businesses are started as either partnerships or companies. In the latter case, where, say, two friends start a new business together they may, inadvertently, find that they have created a legal relationship beyond which they had anticipated. 

Section 1 of the Partnership Act 1890 (“the Partnership Act”) provides as follows:

     “(1)     Partnership is the relationship which subsists between persons carrying on a business in

  common with a view of profit”.

The fact that two or more parties get together and start to run a business is enough to bring into play all of the provisions of the Partnership Act, and those are fairly wide reaching. Key provisions include the following:

  • Subject to any agreement to the contrary, all of the partners are entitled to share equally in the profits of the business. They also have the privilege to contribute, equally, towards its losses, whether those are of a capital or income nature.
  • All of the partners enjoy unlimited liability for all of the debts of the partnership. So, if one of the partners suddenly goes off the rails or incurs business expenses or costs which have not been agreed, or the business folds and a partner disappears, the remaining partners can find themselves in the unenviable position of having full and unlimited liability for the debts of the business.
  • Each partner has the right to take part in the management of the partnership, with most decisions being made by majority decisions. Decisions outside the scope of day to day matters require unanimity.
  • New partners can’t be admitted without the unanimous agreement of all those currently in the partnership – nor can one partner be expelled by the others unless there is a prior agreement in place which permits this.
  • Crucially, a partnership of this kind is known as a “partnership at will”, the consequence of which is that any one of the partners has the power, unilaterally, to dissolve the partnership. In theory, notice of dissolution does not even need to be given in writing although, for evidential purposes, it virtually always is. In circumstances where parents and children are in business together and, sadly, a parent dies, that can also bring about the end of the partnership and trigger a subsequent squabble between the deceased’s beneficiaries and the remaining partner/heirs as to the best way forward.

Companies

The other popular alternative for new businesses run by friends and families is to set up a company.  Companies are governed by the Companies Act 2006 and the model articles of association which set out the default position for its owners, the shareholders. 

In circumstances where, say, a couple of friends set up in business together, difficulties can arise because:

  • Sometimes shares are not allocated as they should be, leading to all kinds of arguments about the legal and beneficial ownership of the company.
  • Although, in a scenario of this kind, it is typically envisaged that everyone will operate control as a director of the company, it is not uncommon for one of the owners not to be registered as a director and, when a dispute subsequently develops between the parties, this can lead to further dispute regarding what was intended and who should control the business moving forward.
  • As with partnerships, mentioned above, it is quite possible for the default provisions set out in the Companies Act and the model articles of association to result in a situation where deadlock can occur.

Deadlock

Deadlock is one of the biggest risks in these circumstances. Without the power to make decisions, in a situation where two former friends have fallen out and are now unable to agree on anything, the default regimes for companies and partnerships can easily lead to a deadlock situation. This can be fatal for a business leading to stagnation and losses being made. Breaking the deadlock is seldom easy and often requires the involvement of the court, not unusually on threat of an application to wind up the business by one of the parties. 

Taking matters into their own hands

In this situation, it’s not uncommon for one of the business partners to attempt to seize control of the business – perhaps even going so far as to exclude their business partner. In that situation, the excluded or prejudiced business partner may need to fall back on their legal rights as set out in legislation and decided cases. However, legal disputes concerning ownership of businesses are notoriously expensive and can result in significant stress, and even bring about the demise of the very business which is the subject of the dispute. 

What can be done to avoid this?

The best chance for a new business to avoid disputes of the kind referred to above, is for it to put in place a proper written agreement regarding the way in which the business should be run. By far the best time to attempt to enter into such agreement is before the business has gotten underway. That’s because, at that stage, the expectations of the parties have not yet been set and (in most cases) at that stage the parties are getting on well and have the best opportunity to successfully negotiate terms between them. 

A partnership or shareholders' agreement can provide clarity and can sensibly include the following:

  • Mechanisms for breaking the deadlock – whether by way of a casting vote, perhaps providing for a chairman’s vote (the chairman might be a neutral party, respected by the other business owners).
  • Include a mechanism for the parties to negotiate and/or buy each other out of the business – perhaps by way of a bidding process that gives both the opportunity to put a bid in for the business and to pay a sum to buy out the other. That way each party has a fair opportunity, if the relationship breaks down, either to be paid the greatest possible sum for their share of the business or, alternatively, to take control of it.
  • Provide for a sale of the business to a third party, in the event that the parties can no longer get on.

These are just a few of the key provisions that can be included in a properly drafted agreement.  Difficulties can (and do) arise where those starting a functioning business draft their own agreements – simply because, without the necessary expertise, the way that what is agreed is expressed in such agreements can give rise to as many problems as it was intended to stop. 

Conclusion

Those going into business together shouldn’t rely on family bonds or friendship as a stable platform on which to build their business. A realistic approach needs to be taken to the fact that disputes may crop up and time spent at the outset, in determining how future disputes can be dealt with can save the parties a great deal of frustration, costs and, potentially, wasted time. 

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