In my career, I’ve had the pleasure of working with businesses of all sizes; from the solo-prenuer to the largest companies in the world. As a business lawyer, I understand legal costs are an ever present budgetary concern. I can certainly sympathize. Particularly at the start up level, the trade off between expensive legal fees and other perhaps more “tangible” capital outlays can seem like a prudent survival-increasing decision.
However, a poor legal structure is not a bad haircut. Your business is not going to grow out of it. It’s more akin to a poorly laid foundation of a home. One day in the future you are going to pay to have the cracks repaired. It will be expensive and sometimes the home will not be salvageable.
You might guess that the cracks in a poor legal foundation show when businesses are in peril. While that is certainly a fairly common occurrence, I have found that more often than not a poor legal structure is significantly more prevalent and damaging in situations where businesses are facing the opportunity for growth and expansion or when the founders of the company are split over a viable exit offer. The timing usually could not be worse.
For all the reasons you started your own business, one of the reasons was because you wanted to win -- whatever that means to you. You should be ready to put your heart, soul and personal reputation behind your venture. You owe it to yourself to build your “home” on a proper foundation.
Pep talk aside, perhaps the lowest hanging fruit in terms of laying a solid legal foundation to a new or existing business is an operating agreement of a limited liability company (“LLC) or the shareholders’ agreement of a corporation. Since the majority of new and small businesses are formed as LLCs, I will use the operating agreement for the discussion here. However, the same concepts apply in a large part for a corporation's shareholder agreement.
From small business owners and start-ups, I often get the question: Do I need an operating agreement? The answer to that question is “YES”. Here are four reasons why:
1) Investors, bankers and potential partners will expect you to have an operating agreement.
Plainly stated, if you want your business to be taken seriously by investors, bankers and potential partners you will have an operating agreement in place.
One of my mentors once told me when evaluating whether to invest in a business, he would use the business’ private restroom. His logic was that how you kept your private, non-public bathroom demonstrated a direct correlation to how the owners kept the internal unseen aspects of the business. If the business kept that bathroom clean and orderly -- then internal structure of the business was likely well kept and attention to detail probably is important to the principals.
I now apply the same analysis when my clients ask for my assessment of a potential business venture or project. If your business does not have an operating agreement, I will typically advise my clients: 1) the business is not ready to be a valuable partner or is a bad investment; 2) the business is too much of a liability to be involved with; and/or 3) the business is probably run by unsophisticated operators and the client can probably negotiate a favorable deal.
When your business is somewhat stable in what I call the “post-survival” stage of business growth, you might look to funding sources and potential partners to sustain the momentum. These potential investors, bankers, other funding sources you will approach will apply the same filter I use and usually demonstrate an even more pragmatic approach in their decision making. For any of these outsiders to take a stake in your company or consider providing financial backing, the lack of an operating agreement may present too much of a risk to get involved.
Put your best foot forward and have your business in order before engaging potential partners and funding sources.
2) All members understand the rules. Expectations are agreed upon in advance.
The first question I ask when I counsel a client concerning a dispute among owners: “Well, what does the operating agreement say?”. Far too often I hear the response, “We don’t have one.”
One of the huge misconceptions about the practice of law is that lawyers are always dealing with new, cutting edge legal issues. On the contrary, most of the potential issues businesses have encountered (both good and bad) have been dealt with before. We can account for and anticipate these issues in a well structured operating agreement. For example, the death of a principal, how capital calls will work, when distributions will occur and the process for one member to sell his or her membership interest can all be determined in the LLC’s operating agreement; mitigating much of the confusion of expectations, expense and damage of these predictable issues.
3) You can avoid litigation with your partners and unnecessary disputes.
That is not to say that you will not encounter issues that are not contemplated in the operating agreement. Yet, without an operating agreement your remedy once all pre-suit compromises are exhausted is a very costly, time-stealing and emotionally taxing lawsuit; most likely without the prospect of recouping legal costs for the prevailing party. Predictably, these disputes regularly end up as a battle of attrition with the lesser capitalized entity tapping out to the expense and burden of commercial litigation. But no one emerges unscathed.
Your LLC's operating agreement can include an arbitration clause that will provide remedy for disputes within the confines of a well defined dispute resolution procedure. The arbitration procedure itself can be quite costly, but ultimately pales in comparison to the cost (time and money) of contested commercial litigation.
Furthermore, the threat paying the legal fees and costs to the prevailing party following arbitration or litigation forces those parties in dispute to truly evaluate the merit of their grievances before escalating the issue to arbitration or litigation.
4) An operating agreement will likely cost less than you think.
As a small business owner myself, when a promising start-up company approaches me for counsel on proper legal structure of a business or other early-stage issues -- my goal is not to make as much money as possible from that new venture at that moment. If I like the company and the entrepreneurs behind it, I look to make that business a long-term client and grow the client relationship alongside the growth of the business. Likewise, if a client approaches me for business counsel and it is willing to take shortcuts or skip foundational components like an operating agreement or a thorough business plan, I am less likely to view that client as a prospective long-term client.
For more information regarding LLC operating or corporate shareholder agreements, contact Blake M. Trueblood at email@example.com or call (954) 302-8610 for a consultation.
This information has been prepared by the Trueblood Law Group, P.A. for informational purposes only and is not legal advice. This information is not intended to create, and receipt of it does not constitute, an attorney-client relationship.