Planning a new business? Nobody wants to think about business difficulties or failures, but planning for them in advance can help you avoid much expense and drama should the worst happen. This advice will help you plan for the end at the beginning of your new venture.
At the outset of a new venture, no one wants to think about failure. However, the oft-cited axiom holds true: if you fail to plan, you plan to fail. One of the most common mistakes people make when starting a new business is thinking that all they need to do are prepare the proper articles for filing with their state’s department of corporations, open a bank account, and they are off and running.
While many follow this bare-bones approach, you will encounter a problem when you have a dispute or change in circumstance that was not contemplated at the outset, and each owner may have a different opinion on the correct course of action. Situations that can create discord if not properly documented include capital call requirements, the addition or withdrawal of owners, the compensation structure for ownership, the plan for management, and which day to day decisions can be made by one owner and those that require a majority or super-majority approval. Starting a business is stressful enough, but by not identifying at the outset the roles each owner will play and the respective duties and obligations of each, you have assured yourself of future problems. The time to plan for the end is at the beginning when all parties are getting along.
This article focuses on the most common form of business structures, the limited liability company (“LLC”), but most principles apply equally to corporations or partnerships. The first decision to be made is the equity structure – how much of the business each member of the company will own. In most LLCs, a member receives an economic interest (reflected as a percentage of ownership) and a management interest. Often, this interest will correspond with a member’s capital contribution to the company, but need not; sometimes one member brings capital while another brings the concept or experience. Either way, it is critical that the equity and management structure be defined at the start.
The desire of a member to leave the company is circumstance ripe for controversy. As a closely held company, there is generally no open market to sell off the interest of a member. More importantly, the remaining members likely do not want to allow the departing member the right to sell her interest to just anyone, as the purchaser will become part of the business. For these and other reasons, it is important not only to include restrictions on the ability to transfer a membership interest but a mechanism by which the value of that departing member’s interest can be determined.
Restrictions on transfer can include the right to assign the equity interest, but not management rights. In many instances, this may be the appropriate method to provide for the reassignment of an ownership interest upon the death of the member. The agreement can provide a right of first refusal where the remaining members must be given the right to acquire the interest of the departing member at the same price agreed to be paid by a third party. Certain future transfers can be agreed upon at the outset, such as transfers to an entity affiliated with one of the existing members. This can be important for estate tax planning purposes.
The method by which to value the interest of a departing member should be determined in advance. Do you want to value the interest as a going concern? As the value of its assets or book value? Or based on an orderly disposition (where the company is sold piecemeal)? Considerations include the lack of an open market for the membership interest, as well as premiums or discounts that should be considered if the interest to be sold reflects a majority or minority of the voting interests. The best time to determine the method to be used for valuing a departing member’s interest is at inception when all parties are presumably more likely to reach an agreement. Whatever valuation method you chose, ensure that your agreement mandates that the determination is final and binding, to help avoid “sour grapes” when the provision is invoked.
Because disputes will inevitably arise, you should provide for the method of resolution in the agreement. Absent an agreement, the default method would be to file a lawsuit in court, but a well-drafted operating agreement will provide methods that could significantly reduce the cost of resolving disputes. A preferred method is to require members to submit their disputes to non-binding mediation, followed by binding arbitration if a resolution is not achieved. Though mediation is not binding, it generally offers the best opportunity to promptly bring the dispute to a neutral who can help the parties work toward an amicable resolution before each side has spent too much time and money fighting over the issue where each now believes that only complete victory is acceptable. If mediation does not succeed, arbitration before a single or panel of arbitrators can provide for a quicker and more cost-effective decision than the court system. Prompt resolution is important to allow the business to return its focus and the energy of its owners to the running of the business.
There are dozens of additional issues you should consider when organizing your new business depending on the nature of the business you are creating and your desired ownership and management structure. Always remember that an operating agreement is a complex document that should be custom-tailored for your unique business arrangement and the needs of its owners. You should have the agreement reviewed periodically to make sure that the provisions are still appropriate for the current business plan and to address any changes that ownership might desire based upon practical experience in the operation of the business.