When starting a business, one of the first things you will need to do is create a legal agreement. This document will outline the basic rules and regulations that govern your company. There are many different types of legal agreements, but in this blog post we will focus on bylaws, LLC operating agreement, shareholders agreement, joint venture agreement, and partnership agreement. Each of these agreements has its own specific purpose, but they all share some common features. We will discuss these features.
What are those documents for?
Bylaws, LLC Operating Agreement (OA), Shareholders Agreement (SHA), Founders Agreement, Joint Venture Agreement, Partnership Agreement - are all different titles for the same type of a legal document. It serves as the primary contract outlining the rights and obligations of business partners in a specific commercial arrangement. It is usually created by the partners at the time of business formation and sets forth the business purpose and how the relationship will be governed.
Why have it in the first place?
- Banks and investors could insist on it. Your bylaws or operating agreement might be requested as evidence that you are the owner of your company. The fact that you own your company may not be shown by your state registration certificate alone. It is therefore better to be prepared and have your operating agreement or bylaws available, even if you are the sole shareholder of your corporation or a single member of the LLC.
- Liability protection. To aid in separating your personal assets from those of the business. Even if it's a single-member company.
Running your business without a required organizational document might compromise your company registration, even if one is not needed in your jurisdiction. Incorporation's primary advantage is the liability protection it provides. It's likely the main reason you established your company in the first place.
Let's briefly go through the definition of liability protection in case you're still unclear. Having a company shields your personal assets, including your house and bank accounts, from anyone suing your firm for various reasons (like damaging property or breaching a contract). You must maintain a clear separation between your personal and professional operations in order to maintain this liability protection. The phrase "commingling funds" refers to treating your corporate resources separately from your personal finances. Additionally, it entails adhering to conventions in business, such as recording meeting minutes. Your chance of someone "piercing the corporate veil" in court, or legally avoiding your liability defenses for failing to handle your corporation like a business, increases if you don't adhere to corporate formalities and don't keep your personal and professional affairs separate.
Without the bylaws or operating agreement, your state might not recognize you as a company, and without it, you might be sued and have your personal assets taken advantage of without any protection. You have already invested the time and work in forming your company. So, get an operating agreement or bylaws to ensure liability protection.
- To prevent unfavorable state laws from interfering. Your state's default laws will be in effect if you don't have an agreement in place. States establish default rules to fill in the gaps if an agreement does not mention particular provisions.
Default rules are created with the goal of permitting outcomes that individuals generally or typically desire. But because they're designed to work in the most minimally viable scenarios, they may have unintended outcomes for firms.
E.g., in the case of your death or incapacitation, your state may have a default law that grants someone the right to inherit the assets of your company, such as a spouse or kid. However, the right to actually manage the inherited property is not necessarily included.
So, if you want a certain individual (such someone who is familiar with the company and has a lengthy history working there) to run your company in the event that something bad occurs to you, you must include it in your agreement.
Checklist of issues to consider
Here are the things to think about:
I. MEMBERS
Membership Classes and
Responsibilities.
Will there be different classes of
members? (voting vs. nonvoting, active vs. passive).
Minimum amount of time contributed by each member?
Will some members have the authority to act freely within
their assigned fields or responsibility, without the need to seek approval of
other members?
What happens if one of the members is not pulling their weight?
Are members allowed to participate in outside business
activities that might be in competition with the company business?
How can
the new members be admitted?
Management. Member managed or manager managed? What would it take to remove a manager?
Indemnification. Disclaim member liability to the fullest extent
allowable by state law or not? Procedures for
indemnification, attorney fees authorized?
II. CAPITAL CONTRIBUTIONS; PROFITS AND LOSSES
Capital Contributions.
Required
initial contribution of each member? Will the members be required to contribute
additional capital to the company after their initial capital contribution? How will sweat equity, IP and in-kind contribution be valued? (It is taxable income to receive a capital interest in exchange for services in an LLC that is taxable as a partnership. So, the higher you valuate the sweat equity the more tax liability you’ll incur. One way to deal with this would be to contribute a nominal amount of cash initially and loan money to the LLC, with interest, by executing promissory note(s) with any or all members. This way everybody would retain their respective percentage ownership and the LLC will be adequately funded without the extra tax burden.)
Profits and Losses. Will profits
and losses be allocated on the basis of ownership percentages? The amounts of any
regular drawings against profits. Will any of the members receive a priority
return over other members (e.g. when one member contributes money and the other just "ideas" that might not even play out)?
III. MEETINGS
Meetings. When will the meetings be required? Email/phone/Skype meetings ok? Who can call a meeting? Is there a quorum requirement? What matters require voting by (i) majority, (ii) supermajority (new members/capital, amendments), and (iii) unanimous (dissolution) consent? Resolution of 50/50 deadlocks - shotgun clause, etc.
IV. TRANSFER OF INTEREST
Sale of Interest.
Company’s right of first refusal before a member can sell the
interest to third parties?
Can the company purchase a member’s
interest upon their death?
Will it be funded with life
insurance?
How will the event of protracted disability of a member be
handled? Period of time in which a former member may not engage in a competing
business.
Penalty for early withdrawal from business (e.g. lower
share valuation if leaves the company within the first year or two)?
Buyout. In what circumstances members
force a member to sell interest and at what price? More on buyout agreements and methods of valuation here.
