July 9, 2015

One of the most important steps for small business owners is to spell out their company’s governance and structure in an organizational document (whether it be an operating agreement, partnership agreement, or corporate bylaws.)  Too often, organizers rely on oral agreements for their company operations rather than investing in a formal written agreement.

“Tension areas” can arise when a company is engaged in a new venture – be it organization, reorganization, sale, or merger – and certain events can exacerbate those tensions.  Higher numbers of members, family members, close friends, and large sums of cash or property are all items that have a history of creating disputes.  For instance, most friends and family don’t want to talk about “who gets what” if their relationship falls apart and may want to skip those provisions in their agreement.  However, when a business is on the line (and its members’ assets along with it), sometimes the only thing that can save relationships from deteriorating is having a properly drafted organizational agreement that will remain unaffected by personal tensions. The same holds true when large sums of money are at stake, or when taxes come due.  There are many situations that should be addressed in an organizational agreement, but here are a few to get started:

  1. Understand that state entity laws may impose “default” rules on the company.

States often have special laws that govern the operations of various business entities (See Missouri’s chapters 347, 358, and 351 for limited liability companies, partnerships, and corporations, respectively.)  Some parts of these laws may be superseded by a company’s organizational agreement.  However, if no such agreement exists, the state rules apply by default.

Take the following example:  A, B, C, and D want to form a business in Missouri and all owners want the option of selling their interest at some point in the future.  They elect to form a close corporation to avoid some of the traditional corporate formalities.  However, if A,B,C, and D do not properly structure their articles of incorporation, not only will the close corporation fail to exist due to a failure to observe statutory drafting requirements, but under Missouri Law, A, B, C, and D, along with any other shareholders, will be prohibited from transferring their shares in the corporation. This could substantially interfere with the marketability of their company.

Another example would pertain to LLCs: A, B, C, and D decide to form an LLC with a five year game plan to sell their interests when their product strikes it big.  A will be working full time for the LLC to get the product ready for market while B, C, and D all agree to keep a steady flow of capital coming into the company.  They decide to form an LLC to take advantage of its ease of governance and for its flow-through taxation.  However, if their LLC does not have an operating agreement that spells out how A will get compensated for his services, A will not be able to require the LLC to pay him until the other members collect a distribution. Additionally, in the absence of a written agreement, B, C, and D will not be required to make additional capital contributions.  After working full time for no pay for a company that is under-capitalized, A is likely to burn out and the product may never reach the market.  By addressing these matters in an operating agreement, A and the company could be protected from this outcome.

These are just two of many “default” rules that apply to Missouri companies.  While these rules can be circumvented by a properly drafted organizational document, they can undermine the parties’ wishes if left unaddressed.

It should also be noted that some states, like Missouri, have statutes that require business owners to execute certain organizational agreements.

  1. Try to plan for repayment of capital contributions and loans

Capital contributions (whether it is property, money, or services) are often a necessary means for a company to operate but can become a point of contention.  Unless suffering from an unusual case of generosity, most investors intend to be repaid their contribution, plus more.  Even if all initial investors are family and friends, they most likely still expect repayment.  Having a governing agreement in place that keeps track of “who put in what” is important.

Individuals who loan or contribute large amounts of cash to a company are likely to want the security of knowing when and how they are going to be repaid.  To address this concern, companies can tailor their organizational agreements to offer investors a bigger chunk of ownership, management, collateral (if dealing with a loan) or some combination thereof.  Mechanisms may include providing a larger return for investors when the company “hits it big,” or perhaps making preferential distributions or dividends.  Other times a set “buy back” date is desired to completely repurchase ownership interests.  It may be better to make an investor’s ownership match their contribution levels, with equal distributions or dividends.  Convertible notes can even be used to give a lender the benefit of equity, and the resulting upside potential, at a later point in time.  Couple these options with call rights, tag-along rights, drag-along rights, and a whole host of preemptive rights and the parties are looking at a fairly complex transaction.  Accordingly, the provisions governing the repayment of capital contributions and loans are a major factor in determining governance, security, and who gets paid first when the company finally turns a profit.

Drafting repayment provisions is important for two reasons:  First, investors and lenders are going to want a written assurance that they will get paid what they believe they are owed.   Second, when the investors and lenders are also friends or family members, (or even other members in the company) having a “pre-agreed” document can help take the heat off of individuals when money gets tight.

  1. Avoid the “who said what” conundrum.

Perhaps the most obvious reason for an organizational agreement is to have a fixed memorandum of the parties’ agreement at the time the company was formed.  Oral agreements are inherently subject to changing recollections and become fuzzy over time.  However, a written agreement provides a company with a “play book” that will survive for the life of the business and will be legally enforceable.

  1. Plan out management

Company management is often an element that does not get addressed sufficiently.   While some of the more obvious issues are usually discussed (such as who will be the CEO and who will handle product development) most owners aren’t aware of the management limitations imposed by law nor do they outline each owner’s authority.

For example, Missouri requires unanimous consent of all members to amend the operating agreement, admit new members, approve a merger or consolidation, or approve any transaction outside of the LLC’s scope.   This may not be a problem in a company’s beginning stages but can quickly become a nightmare if the company issues membership interests to investors or if the members have a falling out at some point.

Corporations have similar rules pertaining to quorums at shareholder and director meetings.  In Missouri, a simple majority of the outstanding shares entitled to vote and a simple majority of the board of directors will constitute a quorum for voting purposes, unless the bylaws indicate otherwise. Additionally, default rules establish when and how board meetings are called, how directors are elected, what officer positions exist, how many votes each share is authorized to have, and the respective authority of officers. These rules, like the ones discussed above, will apply unless modified by the company’s articles or bylaws.

  1. Understand taxes.

Most business owners are familiar with the basic concepts of flow-through taxation for partnerships and S Corporations and double taxation for corporations.  However, each entity structure must comply with the Internal Revenue Code (IRC) in order to reduce tax burdens on individual partners or shareholders.

Most business lawyers have secured at least some familiarity with the mantra of partnership tax: a partner’s outside basis is increased by a partner’s share of partnership liabilities and contributions (IRC § 722) and decreased by a partner’s deceased share of liabilities and distributions (IRC § 705 and § 733.)  IRC § 704 provides that a partner’s distributive share of partnership income, gain, loss, deduction, or credit is determined by the partnership agreement.  Keeping these principals in mind, any partnership agreement (or operating agreement for an LLC taxed as a partnership) should address how and when each partner is allocated income and liabilities, who is obligated to make contributions to the partnership, and when distributions are made.  This will help the partners understand their respective tax liabilities, as well as their financial obligations to the partnership.

Corporations have unique rules governing redemptions and their effect on constructive dividends.  Under IRC § 302, in certain circumstances, shareholders can have the corporation redeem their shares and treat the redemption as an exchange rather than as a dividend, garnering favorable tax results for the shareholder (assuming the stockholder owns less than 50% of the corporation’s voting shares and that the stockholder’s overall ownership percentage of the corporation’s voting and common stock (taking into consideration family attribution rules) after the redemption is less than 80% of the percentage of the total voting and common stock before the transaction).  The bylaws can help facilitate these types of transactions by clearly spelling out “who owns what.”

Whether taxed as a partnership or corporation, the provisions of a company’s agreement can create tax implications for the owners.  Tax deferment, recognized gains, and ordinary income/capital gains classifications all need to be addressed at the outset of a company’s creation in order to take advantage of tax benefits during the company’s life-span. Since these provisions are inherently complex, a clearly drafted organizational agreement can help the owners understand the tax effects of their company structure.

The above items are only a few of the many issues that should be addressed in any company’s organizational agreement.  Each venture is unique and will trigger certain obligations under the IRC and federal and state laws.  Proactive planning and drafting is necessary to advance cooperative relationships between the owners and to encourage asset protection.

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