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Understanding the Importance of a Deadlock Provision

When two or more people start a business together, it is easy to focus on growth opportunities and overlook what happens if the owners later disagree on major decisions. While many disputes can be resolved through communication and compromise, some disagreements become so significant that the business cannot move forward. When owners reach a standstill and no one has the authority to break the tie, the business may face what is commonly known as a “deadlock.” One of the most effective tools for addressing these issues is a carefully drafted deadlock provision within the governing document.

What Is a Deadlock?

A deadlock occurs when business owners or governing persons with equal decision-making authority cannot agree on an important matter, preventing the company from taking action.

Deadlocks most commonly arise in two scenarios:

Even Number of Owners. A deadlock is most likely to occur when an entity has an even number of owners with equal voting rights, such as two owners who each hold a fifty percent interest. In that structure, neither owner can approve major decisions without the other owner’s consent. If the owners disagree and the governing document does not provide a way to break the tie, the entity may be unable to move forward on important matters.

Even Number of Governing Persons. A deadlock can also occur when an entity is managed by an even number of governing persons, such as managers, directors, or committee members, and no tiebreaker mechanism exists. In that structure, the governing body may be evenly divided on a decision, with the same number of votes in favor and against. If the governing document does not provide a way to break the tie, the entity may be unable to approve the action, even when the ownership interests themselves are not equally divided.

Common deadlock scenarios include disputes over whether to accept a buyout offer, whether to admit new owners or raise capital, disagreements over the direction of the business, disputes over compensation or distributions, and irreconcilable differences between co-governing persons over day-to-day operations.

The Potential Harms Caused by a Deadlock

A deadlock that is not resolved quickly can cause significant and lasting harm to the business and to all of its owners. The damage may take several forms.

Operational Paralysis. If the company cannot take action on matters requiring owner or governing person approval, day-to-day operations can grind to a halt. Vendors go unpaid, contracts lapse, opportunities are missed, and employees become uncertain about their futures.

Destruction of Business Value. The longer a deadlock persists, the more value the company can lose. Customers lose confidence, relationships deteriorate, and the company’s position in the market weakens. What might have been a thriving enterprise can become worth a fraction of its former value by the time a resolution is reached.

Costly Litigation. In Texas, when an entity is deadlocked and no resolution mechanism exists, an owner may petition a court for involuntary dissolution under the Texas Business Organizations Code. Judicial dissolution is an expensive, time consuming, and often unpredictable remedy. It also tends to be a last resort that benefits no one, since the forced wind-down of a business rarely produces the value that an orderly resolution would.

Damaged Relationships. Even when a deadlock is eventually resolved, the process of resolving it can permanently damage the personal and professional relationships among the owners. A well-drafted governing document can reduce tension in an already difficult situation by providing an agreed upon roadmap, rather than leaving the parties to dispute both the process and the substance.

Common Deadlock Provisions

There is no single correct way to address deadlocks in a governing document. The right approach depends on the nature of the business, the relationship between the owners, and the kinds of decisions that are most likely to generate disagreement. The following are examples of frequently used deadlock provisions, each with its own advantages and limitations:

Designated Tiebreaker. One approach is to designate a specific individual or position with the authority to cast a deciding vote when a deadlock occurs. This might be a neutral third-party, an independent director, or a senior officer of the company. The tiebreaker can be given authority over all deadlocked matters or limited to specific categories of decisions. The advantage of this approach is that it can provide a clear and efficient way to move past an impasse. The limitation is that it requires the parties to agree in advance on a tiebreaker they both trust, and it places significant power in the hands of a single individual whose judgment may not always align with either party’s interests.

Mediation and Escalation Procedures. Many governing documents require mediation before litigation or other remedies may proceed, and some also require disputes to be escalated to senior leadership or a designated committee first. Mediation can be faster and less expensive than litigation and may help preserve business relationships, but it only works if the parties are willing to compromise.

Shotgun or Buy-Sell Provisions. A shotgun clause allows one owner to offer either to buy the other owner’s interest or sell their own interest at a stated price, and the receiving party must choose which side of the transaction to take. Because the triggering party could end up as either the buyer or seller, there is a strong incentive to propose a fair price. These provisions can work well in equal ownership structures but may create issues when one party has significantly greater financial resources than the other.

Drafting Considerations

When drafting or reviewing deadlock provisions for an entity, counsel should consider the following key issues.

Trigger Events. The agreement should define precisely what constitutes a deadlock and what conditions must be satisfied before the deadlock mechanism is activated. Vague trigger language can lead to disputes about whether the mechanism has even been properly invoked.

Notice and Timing Requirements. Most deadlock provisions require formal written notice to be delivered in a prescribed manner and within specific timeframes. These requirements must be clear, reasonable, and consistent with the practical realities of the business and its owners.

Scope of the Provision. The parties should consider whether the deadlock provision applies to all decisions on which a deadlock can occur, or only to certain categories of decisions. Some matters, such as fundamental changes to the company or amendments to the governing document itself, may warrant different treatment than routine operational disputes.

Financing Contingencies. Where a buy-sell mechanism is included, the agreement should address what happens if the buying party cannot secure financing within the required timeframe. Failure to address this issue can make the deadlock provision difficult to enforce as a practical matter.

Valuation Methodology. If an appraisal or independent valuation is contemplated, the agreement should specify how the appraiser is selected, what valuation methodology applies, how the cost of the appraisal is allocated, and what happens if the parties dispute the appraiser’s conclusions.

Our business and corporate law attorneys at Rapp & Krock regularly advise clients on the drafting, negotiation, and enforcement of governing documents for entities. Whether you are forming a new entity, bringing on a new owner, or reviewing an existing agreement for potential vulnerabilities, we can help you structure a governing document that addresses the full range of risks your business faces, including the risk of deadlock.

ABOUT THE AUTHOR: Jessica Chan is an Associate at Rapp & Krock, PC in the Business Transactions group and focuses on business and transactional law matters, including intellectual property and corporate governance.

Rapp & Krock, PC presents the information in this article for general educational purposes only. Although this article discusses legal issues, it is not legal advice. The law and the content of any linked website may have changed since this article was written, and Rapp & Krock, PC makes no warranty or guarantee about the continuing accuracy of the information presented. Use of this article does not create an attorney-client relationship, and Rapp & Krock, PC does not represent you unless and until we are expressly retained in writing.