Will Your Business's Legal Structure Work?
Will your business’s legal structure work?
Does your business have a legal structure that will guide ownership through both success and hard times?
Closely held businesses are a vital and volatile element of the business landscape. Some new small businesses fail in the first year and many more in the first five years. If you live in an urban area you have seen enough retail store fronts and restaurants come and go to know that creating a new business is not a venture for the faint of heart. However, there are countless success stories of people coming together and creating a concept that succeeds, either on the local level or as a broader national brand.
There are well-capitalized national brands that have many locations; not surprisingly, these are typically not the ones that fold quickly. But many if not most local businesses are closely-held businesses, meaning business units owned and operated by a small group of individuals, or a group of individuals on the operational level with some source of funding. These business arrangements frequently are launched without a carefully crafted written agreement or any agreement at all. At the formative stages, the parties are quick to try and nail down the basic financial parameters but, frequently, insufficient thought is given to the nuances of an ongoing business relationship. Any new business can be a complicated and nuanced endeavor, with many moving parts in which something can go wrong.
Key issues to establish in a business agreement
Whether it’s a partnership agreement, corporate shareholders’ agreement or a limited liability company operating agreement, the agreement between the parties should, but frequently does not, address issues relating to (i) succession of control and ownership; (ii) delegation of management; (iii) relationship with key employees; (iv) critical decision making; (v) dispute resolution; (vi) assignment or sale of the business; (vii) resignation, disability or termination of a principal; (viii) valuation; (ix) drag along or tag along rights; (x) financing; and (xi) exit strategies.
If the business is successful, these issues may all come to a head when the time comes to sell or bring in equity. Parties are rarely in alignment on how that should be done and if the written understanding is silent, how does that get resolved? On the other hand, if circumstances are less kind and the business struggles, how do the parties determine their path if their agreement says nothing about it? In a worst-case scenario, how do the parties work together through a dissolution or liquidation without a proper agreement? There are many litigations that have arisen from the failure of a meeting of the minds on these crucial issues.
If you are an entrepreneur, it is never too late to examine these issues. Ideally, a good lawyer will draft an agreement at the outset for a start up business that assumes both the best and the worst and sets up a strategy and procedure for dealing with either. These concepts are best dealt with while the parties are still in the planning stages, although it can be hard to get people to focus on a plan that contemplates failure when they are trying to succeed.
But if the business has launched and has a life of its own, or even if there is trouble on the horizon, it is not too late for the principals to sit down and map out what is supposed to happen in the event of different contingencies, both negative and positive.
What type of agreement is needed?
The concept of an organic structural agreement is something that can be approached at any point in the life of the business. Here’s how to do it. Establish what form of entity the business is operating under. That determines the type of agreement that is needed: partnership agreement (for a general or limited partnership); shareholders agreement (for a corporation, either an S corp or a C Corp); or operating agreement (for a limited liability company). Two or more people in business together who have not formed a business entity will most likely be treated as a general partnership.
It is most productive for individuals to approach this discussion initially on a layperson level and not get bogged down in legalities. The legal structure can be adapted to fit the business and personal realities of the situation. Start with the actual business: who runs the business? How are responsibilities allocated? How are decisions made? Is everyone happy with these arrangements? The principals need to define on a prospective basis how these matters are going to be handled. This frequently means that the process of defining in writing how the business is going to work ends up being a negotiation on how things can be changed to operate more fairly and efficiently.
Some businesses allocate decision-making by responsibility: one person makes supply and vendor decisions, another makes personnel decisions, yet another makes financial decisions. This is more efficient than having everyone involved in every decision, but some people cannot delegate or surrender any element of control.
How to make an agreement work
The level of trust among the principals will be crucial in determining how this agreement will work. Major decisions should be made by a vote. Is the vote by majority or unanimous? The principals need to imagine every major decision that may have to be made, including firing a major participant or selling the business. How are these decisions going to be made in a way that everyone is comfortable with? The personalities that are involved are an unavoidable factor in these considerations. No matter how sensible a particular approach may be, it will not work if one or more of the principals does not buy into it. The principals have to find a way to compromise on a system of management, decision making and revenue sharing that everyone will agree to, even if very reluctantly.
A closely-held business is analogous to a family. People fight in families. There will be controversies and disputes. Most of them will be resolved informally. But the agreement needs to deal with disputes and the actions that led to them if they cannot be resolved. The obligations of the principals should be defined as precisely as possible. Most disputes will arise either over money (dealt with below) or because someone is accused of not fulfilling those obligations. The person creating the agreement will have to try and craft a mechanism suitable for the parties involved that allow for parties to be put on notice concerning unacceptable performance or behavior, and then there needs to be a mechanism to remove a principal if that conduct cannot be cured.
Money drives everything
Finally, there’s money. Concerns about money lie at the bottom of most of the motivations driving a small business. The agreement needs to define as clearly as possible what the responsibilities, obligations and rights are for each party with respect to what is being contributed, what is being earned and what is being returned. There should not be in any part of the agreement, but particularly here, any “agreements to agree,” or promises to consider changes in the financial terms of the agreement that are undefined. This will only lead to bitterness and litigation. The parties need to agree on exactly what everyone’s share of any financial calculation is and if the actual numbers cannot be known, as is frequently the case, then a formula needs to be developed. The agreement should contemplate such events as the death of a principal or a retirement and the financial considerations attendant to those events need to be addressed. A death buyout of a principal can be funded by insurance, for instance.
Everything comes to an end and someday this business will be closed, sold or passed on to a next generation of leadership. The agreement needs to address those events and define how those events will work. It is not advisable to say let’s deal with that when we get there, because by then expectations, reasonable or not, will be baked into the collective personality of the group. There will be no dissuading people from what they think they deserve or who they think is responsible if the business is a failure. The agreement needs to anticipate those developments and not leave it up to the emotions of the moment to define what happens.
It is a lot to consider. And difficult to do while you’re trying to launch a business. But the more of the future that is dealt with now in writing, the less you have to worry about the future when it becomes the present.