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Business Partners Should Talk About Breaking Up First

Handshake between business partners.

Talk about your business relationship, reduce it to a written agreement, sign it, then get to work with your partner.

When assisting business partners form their entities or when my litigation partner is consulting with me on a case I see the following scenario often:

A business partnership starts with a money person and an idea person. The idea person has a fantastic business plan and the money person has the cash. They think it is perfect. They rush to form a LLC or corporation, downloading an Operating Agreement or Bylaws from the Internet. It even might be worst, they do not even bother with a document. After that, they are running their business, but then several months into it they are fighting.

What do Business Partners Fight About?

Usually, they do not see eye-to-eye on major business decisions.  Decisions like:

  1. how much money should each person contribute;
  2. who has the authority to sign checks or what is the dollar limit each partner has for contract obligations;
  3. where should we locate our offices;
  4. when do we pay ourselves;
  5. what happens when one of us wants to leave; and
  6. so many other issues …

Business owners hate hearing this from their attorneys: slow down! They should be deliberative in their collaboration with their business partner. I sometimes remind people that getting a business partner is basically getting married. Also partnering with a friend is different than being a friend, you sometimes do not know their work ethic. This is why we urge business owners to get things in writing with their partners.

The goal when drafting Operating Agreements, Bylaws, and employment agreements* should be what are the processes that governs decision-making, what happens when there is disagreement, or if an owner wants to leave, etc. … Basically, preempt the fights by setting up contractual arrangements. *By the way, if an owner of a business wants to contribute work instead of capital, then the partners should consider an employment agreement. It is solely not just for contract law purposes, but for tax and accounting issues.

Business partners think that their idea will be a money-maker and that their partner is going to make it happen.  They fail to calculate that even in success that their business partner may have other ideas on the direction of the business.  There is nothing wrong with differences of opinion, but when decision-making is paralyzed it could stop the business from moving forward. Further, for its employees, vendors, and service-providers, knowledge of an ongoing dispute amongst the business owners can make them question the survivability of the business.

Protect your Business Relationship by Communicating

It is easy. Talk about it, come to an agreement, and then get it in writing before the business starts. Many people just want us attorneys to give them their documents or download their own forms for the Internet. They think it saves them time and money.  I’d contend that is the wrong way to look at it. The time and money spent on your governing documents is an investment in the relationship. They are a contractual foundation.

If not, you are just pushing disputes to a later date. Consider that when the money has been spent, you’ve worked countless days and nights, and now you are arguing.  Then you realize all you have for your contract rights is a poorly drafted document … or worst yet, you don’t have one at all.  So do yourself a favor, have the conversation now and plan for the future.  Communicating when you are on good terms with a partner is easier, then when you are fighting.

DISCLAIMER: This post discusses general legal issues, but does not constitute legal advice in any respect.  No reader should act or refrain from acting based on information contained in the post without seeking the advice of  an attorney in the relevant jurisdiction.  Hew & Bordenave, LLLP expressly disclaims all liability in respect to any actions taken or not taken based on the contents of this post.

For LLC Owners: The Difference Between Allocations and Distributions

“Why do I have to pay taxes on money that did not get distributed?!”

This is a question that many LLC owners (know as “members”) ask me. The confusion (and obviously frustration) of paying out taxes on money that you never received is real, but much of it stems from the lack of understanding that in the realm of LLCs there are “allocations”, which handles how profits and losses are allocated among the members and there are “distributions” the actual distributing of cash or property from the LLC. Many business owners like to conflate the two concepts together, which is not the case, and thus creates their confusion.

I provide an informational sheet for readers to take a look and get the basic understanding of the difference between allocations and distributions (see below).  The tax matter aside, the divvying up of allocations and distributions that is a discussion that business owners should have prior to organizing a LLC and then having an operating agreement drafted for them because of not just the tax issue, but due to the flexibility of LLCs of having allocations and distributions not match ownership interest, and the timing of distributions.

Again, communication is fundamental for business owners and a lot of discussion and pre-planning goes a long way to avoid the deterioration of the relationship because these were not hashed out prior to the formation of the business. As discussed in previous posts, LLC owners starting out would want these agreed upon terms on allocations and distributions reduced to writing, and is usually found in the Operating Agreement.

If you would like to see the information sheet, click here and then look for the downloadable pdf entitled, “For LLC Owners: Difference between Allocation and Distribution”.

Mahalo for stopping by and reading my blawg!

-RKH

Episode I: You May Dispense with the Pleasantries, Not the Formalities . . . Don’t Forget to Sign!

*Disclaimer:  This post discusses general legal issues, but does not constitute legal advice in any respect.  No reader should act or refrain from acting based on information contained herein without seeking the advice of counsel in the relevant jurisdiction.  Ryan K. Hew, Attorney At Law, LLLC expressly disclaims all liability in respect to any actions taken or not taken based on the contents of this post.

So I am going start this post with one of my favorite movie villain’s quote: “You may dispense with the pleasantries, Commander. I am here to put you back on schedule.”

Except instead of building a space station, I am here to help you build your business by recognizing that while you can skip the pleasantries in business, you should NOT ignore the legal formalities.  I realize some of you business owners find your attorney, CPA, compliance officer, and the like as pains in the butt by sometimes being overly cautious, but please understand that these advisors suggest caution because they see how bad it can get when you don’t follow their advice.  So this post and several that will follow shall focus on legal formalities that I have seen business owners fail to follow.  By failing to observing these simple formalities these owners spent great time and expense trying to fix them, and some of them are unfixable.

Sign Your Papers

So today’s post what am I talking about?  Well, for this post I am talking about something so basic.  Namely, don’t forget to sign your agreements.   Before you laugh, consider how many times some asks you to do something so simple, you procrastinate on it to the last minute because you think it is so simple take care of later.  Consider in that in today’s technological world it is easy to text, email, etc . . . so some people feel, why bother signing a piece of paper?  Let me share a story that I see constantly among current and past clients: the unsigned Operating Agreement/Bylaws/Partnership Agreement.

I have had clients who have gotten into disputes with their business partners.  It might be suspicions, poor communications, changed expectations, but in general the relationship is deteriorating and these former allies, now want the other side out of the business or they want their share bought out.

So by the time the distressed business partner comes to me I will ask, “Where is your Operating Agreement?” I will be using a LLC as an example, but this applies to corporations, partnerships, and in general many relationships.  They usually have an Operating Agreement and aside from the host of other problems, such as lack of adequate protection, incorrect names or usage of terms, etc . . . I get to the end of the document and find it is unsigned.

What’s an Operating Agreement?

Before I continue, let me explain something about an Operating Agreement. This document acts as internal document that sets up the rules and procedures among the members (the owners) of a LLC, and may dictate how one becomes a member, sells their ownership interest, and handles voting, profit-sharing, etc . . . Suffice it to say, you should have an Operating Agreement if you have a LLC, regardless if it is member-managed or manager-managed.  It gives you the rules of interaction.  I have even seen problems where clients did not even bother having an Operating Agreement drafted, which is just worst than not even having one unsigned.

The Problem with Unexecuted Paperwork

Anyway, when your Operating Agreement remains unexecuted (unsigned) or any paperwork for that matter, it would indicate to an attorney that the parties had no intent to be bound by the document.  After all, “why didn’t you sign it?” is the question that comes to mind.

Unsigned documents are just paper with pretty words.  In the law we expect you to take an active act to be bound by those pretty words, and that active act is signing the documents.  The signature serves as evidence.  Consider for a moment that is why even in our electronic world, we make you go through hoops to “click”, “check the box”, or “electronically sign”, basically showing that you “read” the terms and by your action you agree to be bound to them.

So getting back to this situation where the parties have a dispute, but have unsigned paperwork the question remains what were the terms of the contract.  It is true in a lawsuit you can prove there was intent to be bound under the agreement by showing that the parties took active steps to be bound by the unsigned document.

However, don’t you think it is easier just to produce a signed document as evidence rather than cobbling together various pieces of evidence to demonstrate that the parties meant to sign it?

With an unsigned Operating Agreement, you may find yourself stuck with the default rules at law to guide your dispute with regard to fellow members in a LLC.  The defaults rule set at law are very broad and offer very little help in resolving a dispute among members.  So if you are going to take time to prepare a proper Operating Agreement that covers all your bases in a LLC relationship, don’t forget to get it signed by your business partners and sign it yourself, that way at least you know what to look at for guidance when problems start.

Stop back and I will talk about some of the problems you may face forgetting to do your Annual Filings or missing a renewal date!  Mahalo for reading!

What’s with All this Paperwork? Part IV Operating Agreements

Pardon the gap in my weekly posts, but I was away and setting up my new office.  This week I will be picking up right where I left off as we survey the documents that a startup founder will likely see as they launch a new business entity.

Quick Recap

Last time, I left off with the corporate bylaws.  Recall that a corporation must have bylaws, which is one of the formalities that face a corporation.  Remember that a LLC is a much more flexible entity and need not have an operating agreement, but will default to the rules provided in the statute.  For more on the differences click here.

So Why Draft an Operating Agreement?

Though you technically don’t need an operating agreement there are two practical realities that you face, which is why should get them drafted anyway.  (1) most major banks and financial institutions, as well as any possible investors (though usually they prefer corporations) will want to see your operating agreement.  (2) If you have a multi-member LLC the default rules are just that, they are default, and they may not capture the business relationship you have among your co-founders.  Further, I have recently had several clients lament to me they wish they had taken advantage of the flexibility of a LLC for getting rid of a lazy partner, getting a better handling of the profit/losses and distributions for tax reasons, etc . . . .

Shameless Self-Promotion: Read My One-Sheet!

So I provide this handy-dandy one-sheet that provides a topical overview of the LLC’s operating agreement.  I urge you read it when you have time.  However, as I appreciate you reading this post, today, I would like to cover things not in that one-sheet.

What is NOT Flexible for Laws Governing Operating Agreements?

So, while many people extoll the virtues of the flexibility of the LLC many people do not know what are the default provisions that cannot be changed by the written agreement.  They are non-waivable provisions and I have run into instances that one or a couple members of a startup would like to oust a lazy member, or someone tries to pull a fast one by drafting the operating agreement this not allowable by law.  So I’d like to cover two areas that come up from to time to time.

(1) Access to Information

When you are a tiny company with 2 or 3 founders trying to navigate your way in a deluge of information, massive competitors, and high costs it is easy to get lost in doing what you have to do and one founder takes over recordkeeping, in some ways becoming the overprotective librarian that does not want to let the kids borrow the books from the library.  This is not possible in a LLC.  No member may unreasonably restrict a member’s right to information or access to the records relating to the LLC’s business or its affairs.   Further, the member or the member’s attorney has every right to access the records so that they may exercise the rights and know their duties under the operating agreement.  So they must have the opportunity to inspect and the ability to copy records during ordinary business hours.  However, for the expense and time the LLC may impose a reasonable charge for furnishing and making copies of the records.

(2) Expulsion of a Member

Similar to family attorneys who oversee a prenuptial agreement and then must face the unpleasantness of divorce, I as a transaction attorney face the same, I happily help founders start their business, but every then and now I face the disappointment that the business relationship does not work out.  Expulsion of a member is  not automatic.  Often times, the interested members of the business just stop talking or communicating with the one they are seeking to oust. Do NOT do that, the member, even if they are lazy or have not shown up for a month, is still a member and has rights.  However, they also have duties.   Thus, the nonwaivable rules provide that the LLC or its members have the right to seek a judicial order to expulse the member for the following reasons:

  1. wrongful conduct hat adversely and materially affect the company’s business;
  2. willfully or persistently committed a material breach of the operating agreement or of a duty owed to the company or the other members or under the applicable law; or
  3. engaged in conduct relating to the company’s business which makes it not reasonably practicable to carry on the business with the member.

Last Word: Records Access for Former Members

This two nonwaivable provisions, which I just wrote about invariably sometimes brings up the discussion of former members.  They were once members and having been expulsed they are trying to clean things on their own end for personal reasons.  The LLC cannot still limit access to the records after they are gone.  However, the former member only has the limited right to access the information to when they were a member of the LLC.

*Disclaimer:  This post discusses general legal issues, but does not constitute legal advice in any respect.  No reader should act or refrain from acting based on information contained herein without seeking the advice of counsel in the relevant jurisdiction.  Ryan K. Hew, Attorney At Law, LLLC expressly disclaims all liability in respect to any actions taken or not taken based on the contents of this post.


What’s with all this Paperwork? Part II Bylaws and Operating Agreements, Keep it In the House!

Quick reminder before I dive into this week’s Draw the Law, I have a talk under Pacific New Media on Social Media and that Law.  Check out the info here.
So last week I talked about Articles of Incorporation versus Articles of Organization.  Recall, that the former were for corporations, and the latter was for LLCs.  In addition, remember that these series of posts are meant to deal with a startup person’s guide to all the paperwork they have to deal with when forming a company.

This week is all about bylaws and operating agreements, which are internal documents as opposed to last week’s documents, where are what get filed with a state agency, so become a matter of public record.  One of the easiest analogies to get is that if the Articles are the birth certificate, then the bylaws or operating agreement represents the skeleton of the company.

Are these Documents Public?

As stated above, these documents are internal. That being said the government and institutions may require you to reveal them in order to do business.  Certain trades or industries a regulating agency may require the filing of your bylaws or operating agreement to do business. For example, to obtain a liquor license in the City and County of Honolulu a LLC must submit its operating agreement.  In addition, financial institutions, like banks (this is just an example of one local bank and is NOT an endorsement of them) will require you to submit your bylaws or operating agreement in order to open a business account.  Finally, for startups venture capital firms, potential investors, etc . . . will definitely want a look at your business structure and may even require you to change them to protect their interest.

So What are These Documents Used For?

Both bylaws and operating agreements are internal documents that guide the behavior among shareholders and members, respectively, as well as officers, directors, and managers.   The documents are contract, agreed upon by the owners at the onset of the company.   Therefore, if the rules are not abided by an offending shareholder, member, officer, director, or manager a breach of contract claim may exist for them not following the rules.

Do I Need to Have these Documents?

This question should show how LLCs are more flexible whereas corporations are more formal.  You must adopt an initial set of bylaws for the corporation you form if you are an incorporator or part of the board of director.  However, with the LLC you may enter an operating agreement with fellow co-members, if you don’t you will have the statute as your default rules for guiding the LLC.  This is one of several differences between the corporate structure versus that of a limited liability company.  As stated in previous posts and my law talk, corporations tend to be more formal, but sought after for startups due to investment and tax benefits whereas LLCs are used for their flexibility and ability to be less formal (thus less administrative costs), and that these differences can be seen when drafting these internal documents.

A Word on Negotiating and Drafting these Documents

Many times, startups and small business co-members like to create their own bylaws or operating agreement without an attorney.  What should be realized about this is that in both cases there are certain provisions that are not waivable.  Further, due to the formality of the corporation and the flexibility of the LLC the distribution of ownership, allocation of profit and losses, etc . . . is not necessarily something that should be done without advice and consulting.

In addition, many of people try to only use one attorney to draft a document that reflects the interest of people coming together for an endeavor. What they don’t realize is that is basically intended to be a long-term business deal and sometimes genuine disagreements amongst the starting owners of the company may force each of them to get an individual attorney to negotiate on their behalf.  Another misconception many people have is that they must adopt Robert’s Rules to guide their meetings in their bylaws or operating agreement because they see it on television or see another organization using them.  Remember I said that these documents are a contract?  Consider that if you fail to live up to your own agreed upon rules you are in breach of the company’s internal guiding document.  Finally, consider that these documents are NOT set in stone and operating agreements and bylaws usually have a method to amend them. Whether the process to amend them is easy or not is up to you.

On a personal note, I would like to impart I have dealt with several companies where the people started out friends and thought they could have an informal situation and ignored their own bylaws or operating agreement.  Then a falling out occurred, and well let’s just it was ugly. Others have tried to draft them on their own with disastrous results not realizing further legal work needs to be done when they want to sell the business or attract investors.

So next week, I will tackle bylaws, and some specifics about them, and the following week after that I will tackle operating agreements.

*Disclaimer:  This post discusses general legal issues, but does not constitute legal advice in any respect.  No reader should act or refrain from acting based on information contained herein without seeking the advice of counsel in the relevant jurisdiction.  Ryan K. Hew, Attorney At Law, LLLC expressly disclaims all liability in respect to any actions taken or not taken based on the contents of this post.