08 Apr U.S. partner dispute a cautionary tale for entrepreneurs

A recent U.S. case involving a small startup that grew beyond all expectation and resulted in a legal dispute between the original business partners holds a number of lessons for Canadian entrepreneurs, Barrie civil litigator Scott Hawryliw tells AdvocateDaily.com.

“When a business starts up, partners are optimistic and enthusiastic and not thinking of the worst-case scenario,” says Hawryliw, founder of SRH Litigation. “Often, there’s either nothing in writing that sets out what each party contributes to and gets out of the business, or there’s just not enough detail. With that in mind, it’s critical that you have a clear and comprehensive agreement between the parties.”

The case involves a headphone company and its three original partners. Before leaving the partnership in 2007 — and seven years prior to Apple purchasing the company for US$3 billion — one partner signed an agreement that he would share in a four per cent royalty on future sales of the headphones, according to media reports. He claimed the royalty applied to future evolutions of the product and not just the specific headphones he contributed to, as was alleged by his former partners, the report adds. The court agreed and awarded him US$25.2 million in unpaid royalties.

The lesson in this case is that even small startups should be thinking about their eventual success at the early stages of the business, Hawryliw says.

“This is a good example of where a company started small but grew to be very large and worth a lot of money,” he says. “Often, people aren’t thorough enough with a partnership agreement at the early stages because they say it’s just a small company.

Hawryliw says he sees this scenario playing out in his practice regularly.

“People often start businesses and have nothing — or very little — in writing, or what they do have isn’t clear or comprehensive for a number of reasons,” he says. “The contract might cover what people get out of the business, but it doesn’t define what people brought in. It might state the split at the beginning, but then things change over time, and that change hasn’t been accounted for in the partner contract.”

At some point, the relationship breaks down, and it becomes apparent the parties have a very different understanding of what each is contributing or should be getting from the business, and that’s what results in the legal dispute, Hawryliw says.

“These are things that might not have caused litigation if it was more thoroughly defined in the written agreement,” he says.

The lesson for Canadian entrepreneurs is to expect the best, but prepare for the worst, Hawryliw says.

“In both the original agreement and any subsequent contract, you need to be clear on the expectations of all parties. It’s critical the original contract is thorough and proper and appropriately amended when changes occur in the business. If your company expands or makes significant progress, then the relationship between the parties can change,” he says.

When such matters come before the court, the judge’s job is to determine what the original understanding of the parties was when they started the business, Hawryliw says.

“In a case where it’s one party’s word against another, it’s going to be a question of who’s believed. The way you get there is with evidence. It’s definitely a problem where it’s a case where it’s one party or founder or partner’s word against the other, and there isn’t very much evidence,” he says.

Where there is a contract that’s not as complete and thorough as it should be, the court will try to fill in the blanks as best it can, Hawryliw says.

‘It might look at evidence from other people who were involved, including employees, suppliers, and customers, or at the written records such as corporate documents, contracts and business correspondence.”

The legal process for resolving such a matter in Canada will be similar to that of the U.S., Hawryliw says.

“If there’s ambiguity in the agreement, a court will try to address that. The parties are going to be stuck with whatever the court believes was the understanding among them, which carries some risk. A much better approach is to have that comprehensive agreement at the beginning.”