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SMALL BUSINESS - February 2004
This simply need not be the case. While it will require some initial dedication of assets, resources, and money, it’s critical for small businesses to ensure that they function in a contractual environment that makes sense in light of their business operations. The adage that “an ounce of prevention is greater than a pound of cure” certainly applies in this situation. Setting priorities These contracts are commonly referred to as “Shareholder Agreements,” “Buy-Sell Agreements,” and with respect to limited liability companies, “Operating Agreements.” These contracts structure the relationship so that no one will be forced to be in business with anyone other than the people they chose to do business with in the first place. At the heart of these agreements lies a right of first refusal for the company and remaining shareholders to buy out any other owner of the business before that owner transfers his shares either upon his death, incapacity, or through sale to a third party. These contracts typically provide for valuation mechanisms so that all shareholders agree up front as to how a shareholder’s equity interest in the business will be valued. Shareholder Agreements form the very foundation of a business’ continuity of existence and are the most important contract a small business can put in place. Avoiding the “battle of the forms” While each small business is certainly unique in the way it handles its various relationships, often these relationships are sealed only by a handshake or by a proposal or a purchase order issued by one party to the other. Doing business on a handshake or by purchase order is fine – until there is a disagreement. Once those disagreements arise, failure to fully flush out the business relationship prior to the disagreement can be a devastating problem. Problems arising out of oral agreements are obvious. In most handshake deals, the only thing that has been agreed upon is the quantity and price of the goods and services to be provided. All other aspects of the business arrangement are unaddressed and, unfortunately, usually end up being decided by a jury or a judge. Purchase orders present an entirely different problem. Contractual disputes arising from business arrangements governed by purchase orders typically arise from the conflicting terms and conditions. While Kentucky statutes actually govern the business transaction, in reality those statutes are not interpreted uniformly, leaving a small business open to litigation. The best way to avoid this scenario altogether is for a small business to enter Master Agreements with its primary customers, vendors, and subcontractors so that agreement can be reached on all pertinent terms and conditions of the parties’ business relationship before controversy arises. This eliminates the exchange of conflicting documents because any subsequent order or memoranda is specifically subject to the terms and conditions of the Master Agreement. Determining recourse However, even if a breach of a contract is addressed in a written agreement, a business is only protected if it has taken steps in the agreement to ensure that the breaching party can in fact pay any damages that result. The best way for a business to buffer itself against thinly capitalized vendors and subcontractors is to ensure that their agreements contain strong indemnity and insurance provisions. Indemnity provisions require a breaching party to pay any damages that are suffered by the other party as a result of the breach. These provisions are necessary in almost every contract. They are, however, only valuable if they are backed by strong insurance requirements to ensure that the party at fault has the funds to pay. While a business may have a clear right of indemnity for damages it has suffered as a result of the breach of contract, if the breaching party’s pockets are not deep enough to pay the indemnity claim, the contract is of no value. If insurance is in place against such a breach, the likelihood of a business recovering on its indemnity claim is substantially increased. Contractual protection of a small business’ assets should be governed by one fundamental rule: If at all possible, memorialize your contractual agreements with customers, vendors, and subcontractors in writing before you actually do business with them. While in some instances this will slow down the pace of your commercial transactions, it will substantially lessen the likelihood that you will have to devote substantial time, energy, money, and resources in law suits filed over commercial disputes.
Henry S. Alford is an attorney with the Louisville law firm of Middleton Reutlinger. He concentrates his practice in Complex Commercial and Business litigation Back to February Issue The Lane Report is a trademark of Lane Communications Group. All other trademarks are the property of their respective owners.
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Our economy is driven by contracts. They define how businesses are structured and how commerce occurs. Typically, larger businesses have the depth of resources to ensure that their business arrangements are memorialized in written agreements. In contrast, given the multitude of demands placed on them, small businesses often neglect to ensure that their contract portfolio will support their business and protect their assets.