Consider these issues before forming a business entity with others.
Going into business with someone always sounds promising and exciting in the beginning but, like a marriage, a successful and rewarding relationship needs to sustain the challenges of everyday stresses. Setting expectations early helps with this process. The most effective way to ensure a successful partnership is to address some of the more difficult issues up front and in writing through a partnership agreement, operating agreement, shareholder agreement or similar document.
You are encouraged to consider the following before entering into an agreement. Some of these considerations will need advice and input from your CPA or tax advisor as well as a more comprehensive conversation with a business attorney. This list is not intended to be comprehensive but should offer initial thoughts for discussions with your future partner(s).
Entity Selection: Choosing the proper entity is the first step when entering into a partnership arrangement. Ownership interests, each owner’s share of profit distributions and tax considerations are all important factors when choosing the type of entity you will form to operate your business. In general terms, a corporation might offer certain tax advantages but voting rights and profit distributions are often tied to ownership unless more complicated structures are established or disproportionate payments are made through other forms of compensation. Alternatively, limited liability companies are generally more flexible where the owners are making unequal contributions and receiving a disproportionate share of profits or management control.
Capitalization: It is important to consider who will contribute what to the company and what will be their ownership interests in return. Will owners be making cash contributions? If owners are making non-cash contributions, how will those be valued for establishing ownership interests and for tax purposes? You will also want to address options and obligations in the event the company needs additional capital to continue, update, or expand its operations. Will the owners be required to contribute additional capital? If not, how are the owners’ interests impacted if additional interests are sold?
Allocations and Distributions of Profits and Losses: Owners should consider how profits and losses will be allocated among the owners for tax purposes. Your agreement should clearly address how net profit distributions to the owners will be made and whether any owners should be entitled to certain compensation before distributions are made. Will net profits be distributed based on ownership interest? Instead, will owners who made disproportionate and/or cash contributions of capital be entitled to a priority return? When capital is raised through equity investments, those owners often receive a higher percentage of net profit distributions until their investment is returned. Before making any distributions, owners should consider what, if any, net profits should be reserved for upcoming cash flow needs, equipment upgrades or expansion plans. Because reserving capital could have negative tax impacts, if owners plan to reserve capital it is preferable to include reference to this in your agreement.
Duties of the Owners: It is very important to have a clear understanding of which owner will be responsible for what, especially if one owner is expected to devote more time than the other. It is important to discuss (and ideally document) the amount of time each owner will devote to business and certain duties they are expected to perform. Even if owners prefer to keep these obligations broad and flexible, it can be crucial to set minimum expectations, particularly if there is conflict later. It is also important to have a clear understanding of whether owners will have a right to engage in outside activities and any limitation on competing activities. If an owner has a right to withdraw from the company, you will want to address any prior minimum notice requirements, the procedure for this, and the effect of the withdrawal on the owner’s ownership interest.
Management Decisions: It is essential to a business’s operations to consider how management decisions will be made. Will decisions be made by majority vote or is a supermajority or unanimous vote required for certain decisions? A unanimous vote requirement can be problematic because an owner with a small interest could effectively have veto rights on a company’s actions. Will votes be made by each person comprising the management team or weighted based on ownership interests? The following is an example of matters for which a super-majority or unanimous vote of the owners may be appropriate.
· To incur debt in excess of a certain amount;
· To sell substantially all of the company’s business assets;
· To maintain cash reserves above typical cash flow needs;
· To make capital calls;
· To admit new equity owners and determine terms for admission;
· To make changes in distribution allocations to the owners;
· To expand or materially change the company’s business purpose;
· To amend the agreement among owners;
· To dissolve the company.
Will individual owners be authorized to make certain decisions and what, if any, limitations will there be on their ability to bind the company? If there will be investors or non-managing owners, your agreement should make clear that these owners do not have authority to make operating decisions and clearly and specifically identify which decisions require their vote.
Intellectual Property: Will the work product developed by the owners for the business be owned by the company or licensed by them to the company instead? In many cases, the company acquires these assets in exchange for the owners developing them in exchange for receiving an equity interest in the company. If the owners are engaged in a similar prior business, you may wish to address pre-existing intellectual property, any exceptions as to what the company might own, and the owners’ rights to continue to engage in such activities.
Transferability of Interests: In most cases, owners will want to restrict their ability to transfer their interests to third-parties so they are not forced into partnerships with others they have not approved. Depending on the type of business, they may opt to make exceptions for immediate family members (as is sometimes the case with an entity that owns real property). Rights of first refusal are often a mechanism used to address this concern, in which event remaining owners have the right to purchase a transferring owner’s interest before they can sell it to a third-party. You will also need to consider how to value an interest being transferred and the terms for payment in the event of a buy-out.
Disputes: In situations where there are disputes among owners, the fastest and least expensive way to resolve them is to require the parties to attempt mediation before going to arbitration or litigating their claims. If the owners agree to this, a provisions requiring mediation and, if appropriate, arbitration should be included in the agreement.
Attorney Conflicts: Clients will have to determine whether their business attorney is representing the company or the owners. If clients wish to have a single attorney represent them, your attorney will either require a waiver of any conflicts of interest or suggest that each owner be represented by their own counsel to better address each party’s individual concerns. Separate representation can become more important if ownership interests or capital contributions are disproportionate.
Connect with Carolyn to discuss personally tailored agreements among owners.
The content of this blog post is for informational purposes only and does not constitute legal advice.