In their desire to cut costs and keep expenses to a minimum, many young companies try to keep legal fees low. Many times this leads company founders to forego essential agreements such as corporate bylaws, partnership agreements and limited liability company operating agreements. In my experience, this problem is more prevalent when the principals involved are friends, relatives or otherwise have a long prior relationship. Clients who rely on mere faith in their partners can be pennywise and pound foolish, eventually facing legal bills – or loss of equity in their company – that far exceed their projected upfront savings.
Each form of business entity needs slightly different documents. A corporation will usually have bylaws and a shareholders agreement, a limited liability company will have an operating agreement, and a partnership, whether a general partnership or some type of limited partnership, should have a partnership agreement.
While each of the business entity types has different names for the owners, those responsible for running the company and the type of ownership stakes in the business, the principles behind each are very similar. For ease of discussion, I refer only to partnerships and partners below, as the reasons for documenting the relationships among the partners apply equally to the other business forms.
Proper documentation of the ownership and responsibilities of the partners should set forth:
- How decisions are made and who has decision-making responsibilities
- How to resolve disputes
- How the partners are compensated and whether and how investment capital (equity) is to be repaid
- Who owns any property, including intellectual property, that is used by the business
- Whether partners can be expelled, and what happens if a partner dies or becomes incapacitated
- How and under what circumstances the partnership can be terminated, and how the business will be dissolved
Any business entity with more than one owner should have a buy-sell agreement covering major events such as death, disability or the resignation of an owner that would require one owner to offer her shares in the business to the remaining owners. A buy-sell agreement either be included in one of the documents listed above or can be the subject of a separate, stand alone agreement.
In the absence of a written agreement, state law will govern the operations and ownership of a partnership. Usually, state law will provide that each partner owns an equal share of the business no matter how much that person has invested in the partnership or how much work they have done to develop the business. In this default scenario, someone who invested $100 may end up with the same ownership stake as someone who invested $500,000. Similarly, state law will decide the number of partners who have to approve certain partnership actions, ranging from selling all or part of the business, dissolving the partnership, or buying equipment for the company. In some cases, only a majority vote will be necessary and in other situations state law will require a unanimous vote – giving every partner veto power over the others. State laws usually also provide that every partner is authorized to bind the partnership – and every other partner – in a contract. In most situations, the default state law rules will not reflect the wishes of the partners, the economic realities of the partnership, or the operations and functions of the business.
A proper partnership agreement, drafted at the formation of the partnership, will set forth the parties’ expectations for both the ownership and operation of the business, providing a clear starting point for negotiations on additional issues that arise as the business develops. The partners can always renegotiate the terms of the existing agreement or address matters that they did not contemplate at the outset. However, the existing partnership agreement will provide the baseline for any negotiations, particularly the threshold for how many votes are needed for changes and how many votes each partner gets.
In 2011 alone, I handled three business divorces where longstanding companies decided to part ways with one of the founders. In each case, the company either had no formal partnership agreement or an inadequate one that did not address the separation of the exiting partner. In each case, the exiting partner had substantial leverage to demand concessions such as additional compensation, the ability to take intellectual property to another company or the waiver of a noncompete agreement. While all of these disputes were eventually resolved to the satisfaction of the remaining partners, each case resulted in legal fees that were at least three times the cost of a properly drafted agreement that would have limited the departing partner’s bargaining power and led to an efficient and inexpensive resolution.