Arbitration/Mediation/Investor Dispute

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Question
Thanks for taking my question Timmy. I'm going to give you the Cliff Notes version of the situation.
Started a company in 2013 with 2 Uninvolved investors. They each agreed to provide $10K in funding in exchange for a percentage of ownership (24.5% each)and I would have 51% and run the company as it's in my field of expertise. Also, they were planning to start a different company of their own, and in exchange, I would be given 24.5% ownership in their company. We formed an S Corporation. In good faith, I filed the appropriate IRS documents giving them ownership. One investor provided the full $10K and at that time, we opened a bank account with all of us listed for transparency (both Officers, one is Secretary, the other Treasurer). However, the other investor, to date, has only invested $1700. In addition, since he had access to our bank account, he went on a little spending spree in Vegas. Based on their original commitment, the company committed to several liabilities, web hosting, platform contract, etc... but since funding was never completed, the company has had to take 2 different loans. So, my questions are; I want to send the investor a Demand Letter that funding be completed by 12/31 or his ownership will be revoked. Can I? Or does it have to be from an attorney? (I'll deduct what he spent in Vegas without permission so his actual total investment is $1260) Also, the company may lose money this year so (because I'm irritated and holding most of the bag here) I almost want to leave him as an owner until AFTER the first of the year so he has to assume some of the responsibility/loss. Should I? What would you recommend? And just as a side note, I did go to the bank, have a Corporate Resolution signed and Notarized suspending their access to the bank account.
Any assistance/guidance you can offer is greatly appreciated! Thanks for your time.

Answer
If you have looked at some of my previous answers you may know that I always advise questioners that mediators act as neutral third parties to disputes and never "get involved" in judging the merits of conflict, but merely use special techniques to help the parties decide how to negotiate their own settlement.

I am not an attorney and cannot give you legal advice but can respond from my mediation, management and consulting experience.  Note that this issue may certainly have legal ramifications and you may wish to consult an attorney at some point.

Clearly it is best to have as much structure created at the outset of starting or building a business rather than in the middle because there are inevitable assumptions and expectations created by each party.  FYI the area of least development in business creation is in break-up or dissolution contingencies, where partners specify what the rules are in case of problems.

Consider doing the following preparatory and proactive steps right away as a good discussion foundation.  Here are my recommendations:

1.  Do your best to document a chronological timeline noting the creation of the business, the promises made and the individual contributed work product, asset contributions, the identification of accounts, or any other contribution.  Also document the rise of the conditions leading to the dispute and record how this plays out.  Note any written agreements or oral agreements and understandings.  These carry the force of law.  

2.  Review your existing documents.  Review whatever written agreements, operating agreements, bylaws or other governing documents you have for guidance about rules for management, if any.  Again, oral agreements count.

3.  Within the framework of the bylaws or operating agreement, now is the time to start formally following these protocols within your corporate governance umbrella of Directors.  It is time for the Directors to meet and make some documented decisions.  I would be doing the following things:  First, memorializing all the organizational agreements such as the ownership deal for investment, etc.  You want to get these documented, voted on and in the minutes as bonafide evidence of the clarity of the deal. Hopefully the agreement was a very simple pay-to-play deal cash for equity.  If you were also considering sweat equity or other uncompensated services or stuff like that you could be in some messy trouble.

Second, assuming the deal was very clean I would wish to pass a resolution that would file a corrected 1120-S for 2013 and 2014.  In this tax returns I would adjust the equity declaration of the partner in arrears and only issue the pro-rata share of of the 24.5% equity.  Note that doing this requires he and you to refile personal 1040s too, but oh well.  Your argument is that the equity was never earned and the tax returns are in error. The partner could disagree and the returns could still be refiled -- you are a majority owner and can control the votes ultimately.  (the third partner's equity percentage does not change, still at 24.5% so his K1 will not change either, but yours will be increased the difference)

If you get that far, you will have successfully created a documentable paper trail justifying the proper level of ownership and can proceed ahead without trying to "revoke" equity, which is very hard to do without some very explicit language in the operating documents allowing it.  I think this is an easier way to go.  If you want to you can still accept his payments in the future and issue additional equity along the way equal to the payments, or not (my recommendation).  

4. As to the Vegas overspending I would not mess with the equity calculations, but merely record a Note Payable to the company for the money, then try to get a repayment agreement in place or other agreement.

5.  Understand your potential legal options.  There is potentially a dispute here nevertheless any litigants will incur a large cost to file suit, and people should count the possible costs of paying for or defending litigation.  Remember that nearly 90% of lawsuits settle before trial so the question is usually not IF people will settle, but when and at what cost.  Disputing parties would be better off to wisely choose a cheaper, faster mediated settlement. As far as I can tell there is not an issue at present that could be successfully litigated, but disputes can become entrenched and problematic.

You can go see a lawyer.  The local Bar Association usually has a referral service that will give you access to an attorney for free.  You may wish to understand the legal landscape.  In most states when a company does not have completed organization documents or operating bylaws, the state has standard statutory bylaws of some type codified and these would be the documents you would rely on legally.  You can get a copy and see if they offer any guidance.  

Once you understand where you are and how you got there you are then in the best position to decide how to proceed.

In the case of a minority partner, typically they have very little leverage unless your operating documents call for a settlement procedure. Note that Partners also have a duty to the partnership to not damage it.  Hence, a partner cannot just demand his "piece" out of the middle if it will precariously damage the partnership interests for all.    

I think I would be looking to take more direct control of the company, and take more control of the Board and officers seats.  I would be looking to create more structure around and separating the terms and conditions and benefits and requirements of investors/equity holders, and the terms and conditions and benefits of employees/contractors providing services.  There is not a compelling reason to give up equity when you can comfortably acquire the same services on a compensation basis.   

These are some ideas.  Feel free to follow up with additional questions.

For your general information, the pros and cons of the types of dispute resolution methods follows.

GOOD LUCK!


Arbitration, Mediation, and Litigation

Arbitration: the referral of a dispute to one or more impartial persons for final and binding determination outside of the judicial system

Benefits of Arbitration:

Confidential, no public record
Limited exchange of documentation, information
Quick, don't have to wait for a court date
Arbitrators have expertise in the subject matter and are trained in conflict resolution
Cheaper than litigation
Preserves business relationships

Negatives of Arbitration

It's often a compromise, no 100% winner
Complex arbitration can be costly
If not satisfied, may litigate the arbitration procedure
Poor results with an unskilled arbitrator
Both parties must agree to cooperate in the process

Mediation: the process by which parties submit their dispute to a neutral third party (the mediator) who works with the parties to reach a settlement of their dispute.

Benefits of Mediation:

Neutral mediator can objectively suggest alternatives not considered before
Parties are directly engaged in negotiating the settlement
Can be quicker than litigation
Less costly than litigation
Preserves business relationships
85% of American Arbitration Association cases mediated find successful solutions

Negatives of Mediation

may not reach a binding decision
unskilled mediator

Litigation: using the judicial system to resolve disputes

Benefits of litigation:

a clear winner and loser
uses a prescribed set of procedures
more predictable outcomes
is final

Negatives of Litigation:

waiting for court dates can do more harm
usually more expensive than mediation and arbitration
part of the public record  

Arbitration/Mediation

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Timmy Chou

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I am a experienced Mediator and a partner in a management consulting firm. As a mediator I work as a third-party neutral and specialize in partnership/shareholder disputes, management/labor issues, company culture difficulties, and family-owned business problems. I can help describe why alternative dispute resolution may be a good choice for you. As an experienced management consultant I may be able to offer creative ideas to help resolve your organizational and business problems and disputes. "If you say conflict, I say opportunity".

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