Business Planning & Corporate Clean Up
Essential Company Documents: Absolute Musts for Both New and Established Businesses
Whether you’re just getting started or celebrating decades in business, you likely have big plans for the future. Maybe you dream of doubling your company’s revenue, selling your enterprise for millions of dollars or launching a brand-new product line. Your first instinct might be to invest in state-of-the-art machinery, fancy office space or perhaps to hire more staff, but one of the simplest value-adding steps you can take is to strengthen the documents that govern your business. For a corporation, this means reviewing your articles of incorporation and bylaws. For a limited liability company, the articles of organization and operating agreement control, and for a partnership, there are typically registration documents with the state and a partnership agreement. These various articles and agreements dictate how decisions are made, voting rights among owners, the amount of shares or membership interests the business is authorized to issue, meeting requirements, accounting practices, tax filings and exit strategies.
Articles of incorporation/organization and partnership registrations are typically the bare minimum required to register with your state as a business. If you stop there, rather than drafting bylaws, an operating agreement or a partnership agreement, then your business typically defaults to state law. While this sounds like an easy option, it can actually cause compliance problems. For example, what if your state requires annual meetings and you’re not holding them? What if your state requires annual financial disclosures to minority owners and you’re not providing that information?
You may be unwittingly agreeing to operate your business in a manner that is very different from your actual practice. We tend to see the ripple effects of this disconnect when businesses apply for loans or enter into a joint venture or asset or equity sale agreement. Standard due diligence quickly reveals missing meeting minutes, inconsistent accounting practices, previously unknown minority shareholder rights, improperly issued shares and other problems. At that point, you may have more than a cleanup problem. Your business could lose value.
Assuming you do have bylaws, an operating agreement or a partnership agreement, do you know what those documents say? Do they cover the essential issues facing your business?
As an example, we often see 50/50 ownership structures, with no tie-break provisions. New business partners see a bright future ahead and don’t want to think about potential disagreements. But consider this, most states empower courts to judicially dissolve companies when owners are truly deadlocked. Take the time now to agree on a fair procedure for resolving disputes. You’re much more likely to settle on a sensible tie-breaking mechanism during a period of calm than when tensions are high.
At a minimum, your company’s governing documents should address the following:
Percentages of Ownership
If your articles list members or shareholders with no breakdown of ownership, then you need to take particular care to memorialize it in your governing documents. Similarly, there should be consistency between the legal names of each owner in the articles and the governing documents (i.e., the articles of organization shouldn’t say John Doe owns 100 units while the operating agreement provides that John Doe Business LLC owns 100 units.)
Share/Unit Certificates
Will the company issue physical share/unit certificates? Or will ownership be tracked internally only, such as with a spreadsheet? If you’ve issued certificates, do you know where they are? Or are some potentially lost? Similarly, have shares or units changed hands without the related certificates being retired?
Management and Titles
Who will operate the business on a day-to-day basis? Are there active and passive owners? If so, when are the active/managing owners required to consult with the passive owners? Certain situations, like a complete sale of the business, are obvious contenders for passive or minority owner voting rights. Other situations may fall into a gray area. For example, do the managing owners need to consult the passive ones before making a substantial equipment purchase? If so, what qualifies as “substantial?” Some of these management issues cross-over into voting rights. We typically recommend that non-majority and passive owners specifically list the situations in which they want to retain voting rights or perhaps even veto power. It may turn out that a “passive” owner wants much more say-so than originally contemplated. These are conversations to have when relationships are still intact.
Officer titles can be equally tricky, and it is important to explain the actual scope of each role. For example, calling one 50% owner a “President” and the other a “Vice-President” is fairly meaningless without context. Does the President have tie-breaking power? Do some decisions fall within the purview of the President and others within the purview of the Vice-President? Will officers be elected or appointed? How often? How will they be removed and/or replaced if there is a problem?
Similarly, if you are appointing non-owners with titles, what is the scope of their power? Can a managing owner completely delegate decision-making to that person? If not, what are the limits?
Voting and Deadlocks
What decisions fall outside the scope of daily management and require a vote? To the extent a vote is required, which decisions require a majority vote (typically 51%) versus a super-majority (typically greater than 75%) or even unanimity. Are there specific voting safeguards for minority or passive owners? Even in a 50/50 ownership structure, it’s worth thinking about using voting safeguards to ensure everyone is equally heard. The loudest voice in the room isn’t always the most insightful one. If one business partner tends to dominate, having a pre-determined list of issues that require a vote can be very useful. Not only does it preserve the division of power among business partners, it prevents impulsive decision-making.
Profits and Distributions
You open a business for many reasons, but at least one of them is to make money. Once your business is profitable, who decides whether money is put back into the business, invested or distributed to the owners? Will there be a vote? Is there a particular person, like a manager or president, who has total discretion over distributions? If money is in fact distributed to owners, will it be allocated along percentages of ownership? Or are there other factors, like preferred shares/units?
Losses, and What Happens if the Company Needs Additional Funds?
Are owners required to contribute additional money? What if an owner can’t or won’t contribute additional funds? Will their percentage of ownership be reduced? Alternatively, will the deficit perhaps be repaid from distributions they would otherwise receive?
Is the Company Authorized to Borrow Money?
Some owners feel very strongly that debt should be avoided at all costs. Others have no problem with borrowing. You won’t know where your business partners stand on these types of issues if you don’t discuss them. Worse, boilerplate templates may include requirements that are inappropriate for your risk profile. For example, some operating agreements require owners to personally guaranty the company’s debt. While this typically elicits more favorable lending terms for the business, it puts your personal assets at risk.
What Happens if an Owner Dies?
Are you prepared for your business partner’s spouse or children to step into their shoes? This can happen if your business partner’s estate plan makes no distinction between their personal and business assets. In a similar vein, there may be no way to prevent their spouse or children from selling to a third party, particularly if that third party has the resources to buy them out and you don’t. This sort of situation is entirely preventable through a buy-sell agreement and appropriate life insurance.
Exits (and other removals)
Can an owner freely sell their interest in the company? Or are there restrictions? In a small business, this is particularly important. You want to retain some control over who you work with day-in, day-out. On the flipside, your business partner’s personal circumstances may necessitate a sale. As with the example of a sudden death, a buy-sell agreement and certain financial planning can ease these types of transitions. While a life insurance policy might not apply in this situation, there are other options, like installment sales or business loans.
What happens if an owner or key employee is caught embezzling from the company, abusing their power or convicted of a felony (among any other myriad number of offenses)? Can the company or other owners force a buy-out of their interests? What is the process for determining that an offense warrants removal, and what are the next steps?
Business Opportunities and Intellectual Property
Do you expect your business partners to disclose all potential opportunities for the betterment of the company? If so, you should memorialize that expectation. Alternatively, if you and your business partners have multiple enterprises and investments, you may want to clarify up front that no such duty exists. Similarly, what expectations do you have about intellectual property? Do you think that every creative service or product your business partners develop belong to the company? Or are you envisioning a more limited scope, like just those services and products that fall within the company’s lines of products and services? These distinctions become more and more important as side-hustles gain in popularity. It may not occur to you that your business partner dreams of selling handmade goods on Etsy or narrating for Audible, but those are completely possible scenarios. By setting expectations up front, you avoid costly legal battles and preserve your business relationships.
Indemnification & Liability
Most entrepreneurs choose a corporate structure in order insulate their personal assets from liability. However, the discussion doesn’t stop there. You should think about whether the company will defend and indemnify against any/all debts, obligations and liabilities, or just certain ones. For example, what if an officer engaged in fraud, bad faith, or willful misconduct? What if there are criminal charges and the person had reasonable cause to know that what they were doing was unlawful? What if they violated their fiduciary duties to the company?
Assuming the above examples negate indemnification, who decides that a disqualifying event has occurred? For some companies, a majority vote by the members takes place. Other companies wait for a final, non-appealable court judgment.
Other considerations include the extent to which the company will advance legal costs, as opposed to reimbursing such costs later. Additionally, who controls the defense and selects the defending law firm? Who decides whether a settlement offer should be accepted or rejected? What if the settlement offer provides an excellent outcome for the company but risks reputational harm to the individual?
Additionally, will the company extend these types of protections just to its owners? Or will it include non-equity officers and employees too?
Logistics
Do you want to hold formal meetings, complete with written notice? Would you like for meetings to be in-person only or is your team comfortable with video and teleconferences? If your team dislikes formal meetings, would you prefer to meet informally and memorialize decisions through written consents? To the extent permissible by your state’s laws, you can choose the format that works best for your business.
Taxes
Companies have numerous tax-treatment options. A single-member LLC is typically taxed as a disregarded entity (i.e., the profits and losses flow through to the individual owner) but can elect to be treated as an S Corp or C Corp (as can multi-member LLCs.) Corporations can make a variety of elections too, including B corp status (which is tied to a public service or mission), C corp and S corp status, and also closely-held corporation distinctions. Partnerships pass through income, deductions, gains and losses but can include nuances as to self-employment. No matter the tax structure you choose, the important thing is that your company’s governing documents consistently reflect that choice. Problems can arise when you use internet legal templates. For example, some templates require S corporation elections and even prohibit changing tax treatment without a vote. If your entity isn’t actually operating as an S Corporation and you need audited financials prepared, that will be immediately flagged.
Winding Down
Most businesses are set up as “perpetual,” but you do have the option to set a limit on the number of years the business will exist. Absent dissolution pursuant to the expiration of a term, there are typically set triggers for dissolution, such as the written consent of either a majority, or all of the owners, the entry of a judicial decree, or administrative dissolution for failing to keep the business active with your state. To wind down in an orderly fashion, your business will need to sell its assets, repay creditors and distribute the remaining funds to its owners. Such “liquidating distributions” may follow the same or a different pattern than normal distributions. For example, in a liquidation situation, the owners may wish to abandon preferred returns and instead repay original capital contributions pro rata by ownership percentage. These are decisions best made when you’re not actually dealing with a liquidation.
Contact Penwell Law <----This section doesn't make sense - Too Long for a CTA and Redundant if keeping the normal CTA below (which is also too long).
Penwell Law is here to customize your governing documents so that you essentially have a “How-To” manual specific to your business. When a tricky situation arises, you should be able to consult your bylaws or operating agreement or partnership agreement and find a solution. Having these procedures in place means fewer tough calls for your team and reduces the risk of relationship-fracturing disputes. It also allows everyone’s energy to go into your business and your growth plans rather than triaging emergencies.
Whether you’re just getting started or scared to look at the governing documents you put in a filing cabinet twenty years ago, we are here to help.
Contact the Penwell Law Team!
We’re here to walk you through all the options for buying, selling or growing a business. No transaction is too big or too small. We routinely handle transactions in excess of $10 million, but we’ve also assisted clients with $5,000 acquisitions. For us, it’s not about the deal size. It’s about helping our clients achieve their goals. Contact us today for a no-cost consultation. You can also book a no-cost consultation directly with any member of our team here: