This post is Part III of a discussion as to why lawyers suggest, and entrepreneurs often prefer, the structure of the limited liability company over other business entities. While the LLC is relatively new in comparison to the corporation, start-ups more often choose the LLC when forming their business. What is it about the LLC that makes a preferred structure for start-ups? As explained in the first installment, there are three reasons the LLC has become so prevalent:
1. Reason #1: The tax advantages of the LLC versus the corporation;
2. Reason #2: The extremely flexible nature of the LLC, allowing wide-latitude in structuring the rights and obligations of the members (i.e., the partners);
3. Reason #3: The user friendly nature of an LLC.
A comparison of the arguable tax advantages of the LLC was the subject of Part I of this discussion, and Part II focused on the flexibility of the LLC and the wide-latitude it provides in structuring the rights and obligations of the partners. This final installment examines the user friendly nature of the LLC, which imposes very few compliance requirements in order to maintain the entity.
Reason #3: The user friendly nature of the LLC.
For consumers, one trademark of good technology is whether it is user friendly. Similarly, the LLC has become a preferred choice of many entrepreneurs because it requires very little to form and then maintain the entity.
A. Formation. The formation of a limited liability company requires very little:
(i) In New York, the form for the Articles of Organization is available online at http://www.dos.ny.gov/corps/llccorp.html#artorg and can be filed by anyone (the "Organizer") without the need of a lawyer or a legal service. The Organizer forms an LLC by filing the Articles of Organization, pursuant to Section 203 of the Limited Liability Company Law, with the Department of State. Any person or entity may be an organizer and the the Organizer does not have to be a member of the LLC.
(ii) Operating Agreement. Pursuant to Section 417 of the New York Limited Liability Company Law (NYLLCL), an Operating Agreement must be entered into by the members. Part II of this series discussed the importance of the Operating Agreement, and the flexibility allowing the members to construct the rights and obligations as the members wish, subject only to express restrictions in the NYLLLCL or as otherwise prohibited by law. The limited liability company Operating Agreement is not filed with the State.
(iii) Publication Requirement. New York maintains an arcane requirement that LLC's publish a notice of the formation of the entity in two newspapers (as designated by the county clerk) for six consecutive weeks. See NYLLCL Section 206. The publication fees vary by county, but regardless are expensive and, quite frankly, an unjustifiable but legally required expense. Upon compliance with the publication requirement, the newspaper will provide an affidavit of publication to be filed with the State. With this ridiculous requirement comes the obvious question: What are the ramifications of failing to publish and can it be corrected? If you have not met the publication requirements, "the authority of such limited liability company to carry on, conduct or transact any business in [New York] shall be suspended." NYLLCL Section 203. However, some courts have held that if the LLC cures the failure after filing the action, the lawsuit can be maintained, and a suspended entity can cure the default. The other major concern is whether the members lose the protection of the LLC, and since the answer is uncertain the ambiguity means it is sensible to comply with the publication requirement.
(iv) Comparison with Corporation. Formation of a corporation is also relatively simple requiring only the filing of the Certificate of Incorporation using a pre-printed and form approved by the New York State Department, see http://www.dos.ny.gov/forms/corporations/1239-f-l.pdf. Unlike the LLC, no publication requirement exists, which obviously saves a considerable expense over formation of the LLC. However, as publication is a one-time requirement, other factors (such as tax advantages) often mean entrepreneurs still prefer the LLC.
B. Tax Filings. Because an LLC does not have a tax status separate from its members, the LLC does not file an entity tax return. While the LLC must prepare an informational filing showing the profit and losses of the LLC's business, see IRS Form 1065, there is no separate determination of tax liability for the LLC and thus no separate tax calculation. The absence of a separate tax existence of the LLC is in contrast to the corporation, which is required to calculate the tax liability of the corporate entity and file a actual (rather than an informational return). Of course, the shareholders also will have an individual tax liability based on any distributions (dividends) received from the corporation. The tax returns of the corporation and the informational return of the LLC must be retained with the records of the entity.
C. Management of the Entity. An LLC is not required to have more than one manager regardless of the number of members. In contrast, a corporation with three or more shareholders must have at least three directors. The requirement of three directors increases the cost of operations, creates additional administrative burdens, and affects the dynamics of managing an entity which is obviously much simpler in the case of an LLC managed by one manager.
D. Maintenance/Administrative Requirements.
(i) Annual Meetings. A corporation must hold an annual meeting of its Directors and of its shareholders. Contrast that with the LLC, which requires no annual meeting, unless the Operating Agreement provides otherwise. And, just because the corporation is only required to hold one annual meeting, significant business decisions should be handled by formal resolutions. Although not required, t is advisable for an LLC to document important resolutions thereby demonstrating that the members observe formalities in the event of an attempt by a third party to pierce the protection afforded the members by the LLC structure.
(ii) Minutes of Meetings. New York State also requires that corporations keep and maintain copies of all meeting minutes. Accordingly, proper Minutes of meetings need to be recorded by a designated person, which preferably is a Corporate Secretary elected annually. Not only are minutes required by law, they may be required by your bank or even parties to a transaction as proof of corporate approval. Additionally, shareholders have a right to review these records upon reasonable demand. If you have a corporation, the record book should contain at a minimum the Articles of Incorporation, by-laws, stock certificates, and copies of resolutions and minutes of corporate meetings. LLCs do not have a requirement to record minutes of meetings, although it is a good idea to do so from a record keeping standpoint and also to demonstrate adherence to corporate formalities.
(iii) Shareholder/Member Lists. Corporations must maintain a list of all of its shareholders, the number and class of shares held by each and the dates when they respectively became the owners of record thereof; LLC's are required to keep a list of its members (together with the contribution and percentage interest) and managers.
(iv) Organizational Documents. Both the corporation and LLC need to keep a copy of the organizational documents, i.e., the Articles of Organization and all amendments of the LLC and Certificate of Formation of the corporation. Further, a copy of the LLC's Operating Agreement or Corporation By Laws shall be kept with the entity records.
E. "But I Heard VCs don't like LLCs." It is often suggested that businesses looking to raise third party financing from VCs or Angels should not form an LLC as the structure will be an obstacle to attracting financing. While this may have been the case a few years ago, the prevalence of the LLC, tax advantage and the flexibility of the LLC as evidence by the ability to draft the Operating Agreement to fit the rights and obligations of the members has, for the most part, put this concern to rest. Importantly, if a future investor insists on a corporation, the LLC members have a right to convert the entity to a corporation. Be forewarned, however, that conversion of an LLC to a corporation gives rise to important tax considerations which should be discussed in advance with a tax professional.
The LLC has certain obvious advantages when compared to a corporation, but choosing the proper entity for your business can be driven by a number of factors, including those that are particular to the nature of your business or your tax situation. Therefore, it is important to consult a lawyer and often a tax advisor before proceeding with the formation of the business structure.
Disclaimer: The discussions in this blog do not constitute legal advise nor create any attorney-client relationship. You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters.
Showing posts with label Operating Agreement. Show all posts
Showing posts with label Operating Agreement. Show all posts
Monday, March 5, 2012
Wednesday, February 22, 2012
Why the LLC is a Favorite for Start Ups (Part II)
This post is Part II of a discussion as to why lawyers suggest, and entrepreneurs often prefer, the structure of the limited liability company over other business entities. While the LLC is relatively new in comparison to the corporation, start-ups more often choose the LLC when forming their business. Therefore, what is it about the LLC that makes a preferred structure for start-ups? As explained in the first installment, there are three reasons the LLC has become so prevalent:
1. Reason #1: The tax advantages of the LLC versus the corporation;
2. Reason #2: The extremely flexible nature of the LLC, allowing wide-latitude in structuring the rights and obligations of the members (i.e., the partners);
3. Reason #3: The user friendly nature of an LLC.
A comparison of the arguable tax advantages of the LLC was the subject of the previous post, while this post focuses on the flexibility of the LLC and the wide-latitude it provides in structuring the rights and obligations of the partners.
Reason #2: The extremely flexible nature of the LLC, allows wide-latitude in structuring the rights and obligations of the members (i.e., the partners).
The document governing the rights and obligations of the members of an LLC is the Operating Agreement. The key aspect of the Operating Agreement is that it is an extremely flexible document and is limited only by what is expressly prohibited or required by the NY LLCL. Therefore, the members can utilize the Operating Agreement to structure the economic and control rights to fit the needs of the members and the business.
A. Do you want the entity controlled by all the members or a manager? Under New York law, LLCs are by default deemed member managed, and thus each member has management authority; however, New York law also allows the members to instead choose to have the LLC managed by a manager or a board of managers, and the manager does not need to be a member of the entity.
B. Do you want all the members to have the same rights? If not, different classes of members can be created based on voting or economic rights, and in fact some members can be given economic but not voting rights. Additionally, economic and voting rights need not be based on ownership percentage in the LLC. Contrast this flexibility with an SCorp which prohibits creating different classes of shareholders. Another alternative is to require super majority or even unanimity for key decisions, leaving the manager to run the day-to-day operations but limiting the authority to protect the rights of minority members when it comes to important substantive issues.
C. Do you want to restrict the transfer, pledge or sale of membership interests? Through the Operating Agreement, the members can elect to include provisions restricting the transfer, pledge or sale of membership interests. Adding provisions such as a right of first refusal, a co-sale right and a prohibition on the pledge of one's membership interests not only (i) limits the ability of a member to dispose of its interests without an opportunity for the other members to also monetize, in part, their interests, but also (ii) means the existing members can preclude the admission of a third party who they may decide is not good for the business.
D. What can be done if I have a dispute with my partner? The members will have an opportunity when drafting the Operating Agreement to include a Buy/Sell provision addressing the rights of the members if a serious and seemingly unresolvable dispute arises. The Buy/Sell provision should detail the procedure for exercising the right and the methodology employed for valuation of the membership interests. See http://mybizlawyer.blogspot.com/2011/09/joint-venture-have-shotgun-clause.html In addition, include a clear dispute resolution clause, as you would in any contract, which states the venue for resolving claims both in terms of the type of tribunal (i.e., court, arbitration, mediation) and the actual geographic location (for example, New York County or Nassau County).
E. What are other examples of what can be included in the Operating Agreement and what are the limitations? Simply put, the the Operating Agreement can include any provision the members decide to incorporate provided it is not prohibited by the New York Limited Liability Company Law (or is otherwise unlawful). Therefore, the members may decide to include, among other clauses, (i) a non-compete clause, (ii) confidentiality restrictions, (iii) provisions adjusting the application of certain tax provisions, (iv) provisions relating to the allocation and distribution of profits and losses, (v) grounds for termination of the LLC, expulsion of a member, or addition of new members and (vi) creation of officer positions (such as a President or CFO), to name a few examples of typical Operating Agreement terms.
F. But I have heard that it is harder to raise funds from investors when you have an LLC as opposed to a corporation? The argument that it is harder to raise funds if you are an LLC as opposed to a corporation does not carry much sway nowadays. The fact is that it is extremely difficult, even in the best economic environment, to raise financing from third party investors. If you are fortunate enough to find investors, it is unlikely they would be dissuaded by the fact that the business is an LLC as opposed to a corporation. Remember, the highly flexible nature of the LLC allows the members to bring in investors with different economic and voting rights, and the LLC is so common place it is rarely a reason investors will be uninterested in your business.
In sum, the Operating Agreement is a contract among the members of the LLC, and therefore the members have the right to adjust the terms to fit their business needs, reflect the contributions of the members, and make the LLC attractive to potential investors.
The final installment on this topic will discuss the operational simplicity and ease of use of the LLC.
Disclaimer: The discussions in this blog do not constitute legal advise nor create any attorney-client relationship. You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters.
1. Reason #1: The tax advantages of the LLC versus the corporation;
2. Reason #2: The extremely flexible nature of the LLC, allowing wide-latitude in structuring the rights and obligations of the members (i.e., the partners);
3. Reason #3: The user friendly nature of an LLC.
A comparison of the arguable tax advantages of the LLC was the subject of the previous post, while this post focuses on the flexibility of the LLC and the wide-latitude it provides in structuring the rights and obligations of the partners.
Reason #2: The extremely flexible nature of the LLC, allows wide-latitude in structuring the rights and obligations of the members (i.e., the partners).
The document governing the rights and obligations of the members of an LLC is the Operating Agreement. The key aspect of the Operating Agreement is that it is an extremely flexible document and is limited only by what is expressly prohibited or required by the NY LLCL. Therefore, the members can utilize the Operating Agreement to structure the economic and control rights to fit the needs of the members and the business.
A. Do you want the entity controlled by all the members or a manager? Under New York law, LLCs are by default deemed member managed, and thus each member has management authority; however, New York law also allows the members to instead choose to have the LLC managed by a manager or a board of managers, and the manager does not need to be a member of the entity.
B. Do you want all the members to have the same rights? If not, different classes of members can be created based on voting or economic rights, and in fact some members can be given economic but not voting rights. Additionally, economic and voting rights need not be based on ownership percentage in the LLC. Contrast this flexibility with an SCorp which prohibits creating different classes of shareholders. Another alternative is to require super majority or even unanimity for key decisions, leaving the manager to run the day-to-day operations but limiting the authority to protect the rights of minority members when it comes to important substantive issues.
C. Do you want to restrict the transfer, pledge or sale of membership interests? Through the Operating Agreement, the members can elect to include provisions restricting the transfer, pledge or sale of membership interests. Adding provisions such as a right of first refusal, a co-sale right and a prohibition on the pledge of one's membership interests not only (i) limits the ability of a member to dispose of its interests without an opportunity for the other members to also monetize, in part, their interests, but also (ii) means the existing members can preclude the admission of a third party who they may decide is not good for the business.
D. What can be done if I have a dispute with my partner? The members will have an opportunity when drafting the Operating Agreement to include a Buy/Sell provision addressing the rights of the members if a serious and seemingly unresolvable dispute arises. The Buy/Sell provision should detail the procedure for exercising the right and the methodology employed for valuation of the membership interests. See http://mybizlawyer.blogspot.com/2011/09/joint-venture-have-shotgun-clause.html In addition, include a clear dispute resolution clause, as you would in any contract, which states the venue for resolving claims both in terms of the type of tribunal (i.e., court, arbitration, mediation) and the actual geographic location (for example, New York County or Nassau County).
E. What are other examples of what can be included in the Operating Agreement and what are the limitations? Simply put, the the Operating Agreement can include any provision the members decide to incorporate provided it is not prohibited by the New York Limited Liability Company Law (or is otherwise unlawful). Therefore, the members may decide to include, among other clauses, (i) a non-compete clause, (ii) confidentiality restrictions, (iii) provisions adjusting the application of certain tax provisions, (iv) provisions relating to the allocation and distribution of profits and losses, (v) grounds for termination of the LLC, expulsion of a member, or addition of new members and (vi) creation of officer positions (such as a President or CFO), to name a few examples of typical Operating Agreement terms.
F. But I have heard that it is harder to raise funds from investors when you have an LLC as opposed to a corporation? The argument that it is harder to raise funds if you are an LLC as opposed to a corporation does not carry much sway nowadays. The fact is that it is extremely difficult, even in the best economic environment, to raise financing from third party investors. If you are fortunate enough to find investors, it is unlikely they would be dissuaded by the fact that the business is an LLC as opposed to a corporation. Remember, the highly flexible nature of the LLC allows the members to bring in investors with different economic and voting rights, and the LLC is so common place it is rarely a reason investors will be uninterested in your business.
In sum, the Operating Agreement is a contract among the members of the LLC, and therefore the members have the right to adjust the terms to fit their business needs, reflect the contributions of the members, and make the LLC attractive to potential investors.
The final installment on this topic will discuss the operational simplicity and ease of use of the LLC.
Disclaimer: The discussions in this blog do not constitute legal advise nor create any attorney-client relationship. You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters.
Wednesday, January 25, 2012
Operating Agreements: Ten Important Provisions
If you are starting a business or have an established business and are bringing in a new partner, you need a written Operating Agreement. In fact, the New York Limited Liability Company Law (NY LLCL) requires that an LLC have an Operating Agreement, failing which the members of the LLC are subjected to an agreement that is essentially created from the provisions of the NY LLCL. See Limited Liability Company Law 417(a). Aside from the statutory requirement of a written agreement, you do not want an operating created from the provisions of the New York LLC law because there are discretionary provisions that the members can change, thereby addressing the particular interests of the members. Below are ten key provisions a business should include or consider including in the Operating Agreement.
1. Member Managed vs. Manager Managed. If you do not specifically address whether the LLC is managed by the members or a manager then by default it is deemed managed by the members. A member managed entity means that each of the members has management rights, and if this is not want the parties desire then it needs to be changed through the Operating Agreement -- indeed, it is unlikely that the majority member wants each member to have control authority. The simple solution is to state in the Operating Agreement that the entity is manager-managed and then expressly state the name of the manager.
2. Having a Vote on Material Matters. Even when the LLC is manager managed (by the majority member) the minority member(s) should try to negotiate to retain a right to veto material financial and business decisions. The manager can still make day-to-day decisions but major issues would require approval of super majority of the members. Among important (material) issues that typically require super-majority approval are (a) a material change in the business of the company, (b) a merger, sale of the business or significant assets, dissolution, bankruptcy or reorganization (c) transactions in excess of a certain amount, (d) amendments to the Operating Agreement, (e) incurring loans in excess of a defined amount, (f) entering into transactions with the LLC members or officers, (g) redemption of membership interests, (h) employment or consulting agreements or increases in compensation of employees/consultant in excess of a certain amount, and (i) even admission of new members. It is not unusual for a minority interest to demand that material issues can only be decided based on approval of a super-majority; therefore, do not assume that because you will own a small (minority) interest you are overreaching in asking for voting rights with respect to material business and financial matters.
3. The Membership Percentage Need Not Dictate Economic and Voting Rights. If the intention is to allocate profits and losses other than based on the percentage of interests a member owns in the LLC or to create separate classes of voting rights, then define the terms in the operating agreement. The Operating Agreement can vary the financial rights of members and create different classes of members, giving partners the flexibility to grant interests in the business that are not strictly defined by percentage of ownership.
4. Tax Provisions. The members can choose to include (or not to include) several significant tax provisions and elections affecting treatment of contributions of property, capital accounts, allocations and distributions and other tax issues. These tax provisions should not be overlooked and should be discussed with an accountant as well.
5. Transfer of Membership Interests. The Operating Agreement should address restrictions on transfer of membership interests, and will often include:
(a) A right of first refusal giving other members the right to purchase offered interests pro rata based on a member's percentage interest in the LLC. The right of first refusal prevents a member from selling its shares to a third party without giving the other members an opportunity to purchase the shares. The right is as much about a chance for members to increase their ownership as it is about excluding the transfer of interests to an undesirable new partner. If you include a right of first refusal, make sure the operating agreement clearly sets forth the procedure and time periods relating to exercise or waiver of the right.
(b) Co-sale rights give members the right to sell a percentage of their interests along side a selling member so that a partner cannot liquidate its interests without giving other members an opportunity to sell some of their shares as well. As with the right of first refusal, be sure to define what is necessary to meet each member's obligations under the co-sale terms.
(c) An exception for transfers made to related parties since an operating agreement will generally require a member obtain approval of for any transfer; however, you may not want your partner's son or husband as a partner so before agreeing to such a provision consider if transfer to a related partner is acceptable.
(d) Although technically not a transfer, a restriction on the pledge or encumbrance of a member's interests. The restriction prevents an involuntary transfer of a partner's interest to a lender or other lien holder that would otherwise occur if the the member defaults on its obligations to the lien holder.
Note: The restrictions on transfer of a member's interests in an Operating Agreement boils down to the simple point that you entered into a business relationship with a partner (or partners), and you do not want a partner to hand over its interests to someone you do not know (or worse, do not like).
6. Buy/Sell Provision. Business partners can grow apart, their involvement or desire to be involved in the business can change, a partner can fail to meet expectations, or a number of other issues can arise whereby a partner wants to leave the business or the other partners want a partner out of the LLC. A Buy/Sell provision will avoid the disputes, distractions, and (yes) legal costs that otherwise inevitably will arise during a business divorce. The Buy/Sell provision should set the terms under which a the LLC or other partner can buyout a partner or a partner can require the LLC to buy its interests. The structure and mechanisms of a Buy/Sell provision are discussed in prior posts, emphasizing the importance of clear terms as to when the provision can be invoked, how the selling interests to be valued, and the procedure for completing the transaction. See http://mybizlawyer.blogspot.com/2011/09/joint-venture-have-shotgun-clause.html
7. Termination. Include the grounds for termination/dissolution of the LLC. Under New York law if you are a minority or equal partner in the LLC a court will not grant an application to dissolve the entity simply because you cannot "get along" with your business partner. In fact, a dysfunctional partnership that still manages to be a successful business generally will not be dissolved by judicial decree under New York law. Therefore, the Operating Agreement should delineate the circumstances under which dissolution of the LLC can occur, including (without limitation) a defined time period, the occurrence of a certain event, or a vote of a majority (or super-majority) of interests. Indeed, if you include a buy/sell provision (as discussed above) and one partner wants to end the business while another does not, then there will be an avenue to address the issue through a buyout.
8. Non-Compete. You may want to include a non-compete clause, and if so it must comply with New York law in terms of geographic scope, time and scope.
9. Dispute Resolution. The dispute resolution clause should set forth the body that will decide any dispute (i.e., a court or arbitration), the venue (place) the matter will be tried (including not only the geographic location but, for example, in the case of an arbitration the arbitral institution), and perhaps that the losing party will be responsible for the legal fees of the prevailing party.
10. Flexibility. The Operating Agreement is an extremely flexible document and is limited only by what is expressly prohibited or required by the NY LLCL. As such, there are a number of other financial and control terms that can be addressed in the Operating Agreement so be sure to take advantage of this flexibility in structuring the rights and obligations of the members when drafting the Operating Agreement.
Disclaimer: The discussions in this blog do not constitute legal advise nor create any attorney-client relationship. You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters.
1. Member Managed vs. Manager Managed. If you do not specifically address whether the LLC is managed by the members or a manager then by default it is deemed managed by the members. A member managed entity means that each of the members has management rights, and if this is not want the parties desire then it needs to be changed through the Operating Agreement -- indeed, it is unlikely that the majority member wants each member to have control authority. The simple solution is to state in the Operating Agreement that the entity is manager-managed and then expressly state the name of the manager.
2. Having a Vote on Material Matters. Even when the LLC is manager managed (by the majority member) the minority member(s) should try to negotiate to retain a right to veto material financial and business decisions. The manager can still make day-to-day decisions but major issues would require approval of super majority of the members. Among important (material) issues that typically require super-majority approval are (a) a material change in the business of the company, (b) a merger, sale of the business or significant assets, dissolution, bankruptcy or reorganization (c) transactions in excess of a certain amount, (d) amendments to the Operating Agreement, (e) incurring loans in excess of a defined amount, (f) entering into transactions with the LLC members or officers, (g) redemption of membership interests, (h) employment or consulting agreements or increases in compensation of employees/consultant in excess of a certain amount, and (i) even admission of new members. It is not unusual for a minority interest to demand that material issues can only be decided based on approval of a super-majority; therefore, do not assume that because you will own a small (minority) interest you are overreaching in asking for voting rights with respect to material business and financial matters.
3. The Membership Percentage Need Not Dictate Economic and Voting Rights. If the intention is to allocate profits and losses other than based on the percentage of interests a member owns in the LLC or to create separate classes of voting rights, then define the terms in the operating agreement. The Operating Agreement can vary the financial rights of members and create different classes of members, giving partners the flexibility to grant interests in the business that are not strictly defined by percentage of ownership.
4. Tax Provisions. The members can choose to include (or not to include) several significant tax provisions and elections affecting treatment of contributions of property, capital accounts, allocations and distributions and other tax issues. These tax provisions should not be overlooked and should be discussed with an accountant as well.
5. Transfer of Membership Interests. The Operating Agreement should address restrictions on transfer of membership interests, and will often include:
(a) A right of first refusal giving other members the right to purchase offered interests pro rata based on a member's percentage interest in the LLC. The right of first refusal prevents a member from selling its shares to a third party without giving the other members an opportunity to purchase the shares. The right is as much about a chance for members to increase their ownership as it is about excluding the transfer of interests to an undesirable new partner. If you include a right of first refusal, make sure the operating agreement clearly sets forth the procedure and time periods relating to exercise or waiver of the right.
(b) Co-sale rights give members the right to sell a percentage of their interests along side a selling member so that a partner cannot liquidate its interests without giving other members an opportunity to sell some of their shares as well. As with the right of first refusal, be sure to define what is necessary to meet each member's obligations under the co-sale terms.
(c) An exception for transfers made to related parties since an operating agreement will generally require a member obtain approval of for any transfer; however, you may not want your partner's son or husband as a partner so before agreeing to such a provision consider if transfer to a related partner is acceptable.
(d) Although technically not a transfer, a restriction on the pledge or encumbrance of a member's interests. The restriction prevents an involuntary transfer of a partner's interest to a lender or other lien holder that would otherwise occur if the the member defaults on its obligations to the lien holder.
Note: The restrictions on transfer of a member's interests in an Operating Agreement boils down to the simple point that you entered into a business relationship with a partner (or partners), and you do not want a partner to hand over its interests to someone you do not know (or worse, do not like).
6. Buy/Sell Provision. Business partners can grow apart, their involvement or desire to be involved in the business can change, a partner can fail to meet expectations, or a number of other issues can arise whereby a partner wants to leave the business or the other partners want a partner out of the LLC. A Buy/Sell provision will avoid the disputes, distractions, and (yes) legal costs that otherwise inevitably will arise during a business divorce. The Buy/Sell provision should set the terms under which a the LLC or other partner can buyout a partner or a partner can require the LLC to buy its interests. The structure and mechanisms of a Buy/Sell provision are discussed in prior posts, emphasizing the importance of clear terms as to when the provision can be invoked, how the selling interests to be valued, and the procedure for completing the transaction. See http://mybizlawyer.blogspot.com/2011/09/joint-venture-have-shotgun-clause.html
7. Termination. Include the grounds for termination/dissolution of the LLC. Under New York law if you are a minority or equal partner in the LLC a court will not grant an application to dissolve the entity simply because you cannot "get along" with your business partner. In fact, a dysfunctional partnership that still manages to be a successful business generally will not be dissolved by judicial decree under New York law. Therefore, the Operating Agreement should delineate the circumstances under which dissolution of the LLC can occur, including (without limitation) a defined time period, the occurrence of a certain event, or a vote of a majority (or super-majority) of interests. Indeed, if you include a buy/sell provision (as discussed above) and one partner wants to end the business while another does not, then there will be an avenue to address the issue through a buyout.
8. Non-Compete. You may want to include a non-compete clause, and if so it must comply with New York law in terms of geographic scope, time and scope.
9. Dispute Resolution. The dispute resolution clause should set forth the body that will decide any dispute (i.e., a court or arbitration), the venue (place) the matter will be tried (including not only the geographic location but, for example, in the case of an arbitration the arbitral institution), and perhaps that the losing party will be responsible for the legal fees of the prevailing party.
10. Flexibility. The Operating Agreement is an extremely flexible document and is limited only by what is expressly prohibited or required by the NY LLCL. As such, there are a number of other financial and control terms that can be addressed in the Operating Agreement so be sure to take advantage of this flexibility in structuring the rights and obligations of the members when drafting the Operating Agreement.
Disclaimer: The discussions in this blog do not constitute legal advise nor create any attorney-client relationship. You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters.
Monday, November 7, 2011
Ten Legal Mistakes Made by Start-Ups: Bringing in a Partner Without a Proper Agreement (#8)
Often start-ups are so excited about bringing in a partner who can offer financing, desperately needed services, or play an advisory role/provide professional advice that the start-up brushes aside the need for a proper agreement detailing the rights and obligations of the new partner.
Myth #8: "This is a start-up and we should be happy to have this new partner so let's not worry scare the partner off by demanding a formal agreement."
If you are involved with a start-up you certainly understand the pressure to attract partners who can offer financing, professional services, or even play an advisory role. All too often, however, this anxious desire to attract such a partner will lead founders to opt to put aside the need to document the rights and obligations of the partner; it may be because of the desire to avoid additional legal costs or simply feeling that asking the potential partner to sign an agreement will scare the partner off. So instead the founder decides to have a simple handshake and issue the new partner shares or membership interests representing a percentage in the business. In no uncertain terms, this is a serious mistake for a number of reasons, including the following:
1. If this is an LLC, do you have an Operating Agreement? If this is a corporation, do you have detailed by laws/shareholder agreement? If this is a partnership, do you have a partnership agreement? If the answer is no, then the new partner has financial and voting interests based on the interests granted in the entity; and any rights and obligations are otherwise governed by the relative state LLC, Corporate or Partnership law. Do you know what the governing law says as far as the financial and management rights of members (LLC)/shareholders (corporation)/partners (partnership)? If not, you may be very surprised later if a dispute arises, at which point it will be too late.
2. What if the new partner fails to do what was promised, dies or becomes disabled? You could have avoided this issue by having the interests vest over time (see http://mybizlawyer.blogspot.com/2011/10/ten-legal-mistakes-made-by-start-ups_28.html) and/or giving the entity and other partners a buyout right (see http://mybizlawyer.blogspot.com/2011/10/shareholder-agreements-define-buyout.html). If you do not attend to this issue, you could be stuck with a non-performing partner and perhaps hanging your hopes on the expensive and time consuming process of proving an oral agreement in court.
3. The partner decides to sell or transfer its interests to a third party you don't know or don't like (or both). Can the partner do this? It depends what the governing law says, but if you had a clear statement of the rights of the partners and a right of first refusal there would be no issue.
4. The new partner just signed a contract binding the entity, one which you would not have approved. In New York, an LLC is deemed to be member-managed unless the Operating Agreement states otherwise, and a s a result each member has the authority to bind the entity. Solution, an Operating Agreement setting forth that the entity is manger-managed, naming the manager, and thereby removing the authority the new member to bind the entity. (See http://mybizlawyer.blogspot.com/2011/09/management-of-llc-member-or-manager.html). Also, LLC and Corporations (but not SCorps) are very flexible structures allowing for the creation of different classes of partners, and therefore you can create a class that has only financial rights and no management/voting rights.
5. You just learned the new partner is starting a competing business or offering services to a competitor and is also trying to solicit your employees, customers, and business partners. If the partner is using trade secrets you still can take seek legal recourse, but again proving the claim is costly and regardless does not address some of the other concerns, like solicitation of your employees. While enforcing a non-competition agreement can be challenging and requires careful consideration before drafting, you should include confidentiality and non-solicitation provisions in the operating agreement/shareholder agreement/partnership agreement.
6. The partner developed services, an application or created products that include certain intellectual property rights and now claims ownership of those products/services or of the underlying intellectual property. In fact, the partner is filing patent claims and then plans on licensing the rights to third parties. You could have avoided any issue with an invention agreement agreement assigning the rights to the inventions and intellectual property to the business. (See http://mybizlawyer.blogspot.com/2011/10/ten-legal-mistakes-made-by-start-ups_24.html).
7. You have a dispute with the new partner, who files a groundless lawsuit in Buffalo, and the other members and the business are located in Long Island. You realize the added burden of litigating a dispute in a court hundreds of miles from where the business is based, and while the your lawyer explains there may be grounds for a motion arguing Buffalo is not a convenient forum for the dispute, the motion will create additional litigation costs. You could have avoided this issue with a venue clause stating all disputes are to be filed in Nassau County, for example. It also may have been beneficial to include a provision awarding attorney fees to the prevailing party, giving the partner pause before filing baseless claims.
While the above is in some ways a recap of prior issues that have been discussed in this blog, the take away here should be that even a start-up has a right to demand a new partner sign an agreement clearly delineating the rights and obligations of the members of the entity. If the new partner refuses or wants you to believe a handshake is enough, you should be very suspicious. There is simply no substitute for a well-drafted agreement to avoid the myriad legal issues that can arise between business partners.
Disclaimer: The above is for discussion purposes only and does not constitute legal advice nor create any attorney-client relationship. There is no substitute for legal advice from an experienced business/corporate lawyer.
Disclaimer: The above is for discussion purposes only and does not constitute legal advice nor create any attorney-client relationship. There is no substitute for legal advice from an experienced business/corporate lawyer.
Wednesday, October 12, 2011
Shareholder Agreements: Define BuyOut Terms
In a prior posting, I noted the importance of setting forth clear terms for buying out another member (LLC) or shareholder (corporation). For example, the buyout terms/shotgun clause can be set forth in the Operating Agreement of an LLC (or a separate agreement between certain members) or in a shareholder agreeement of a corporation. The dispute between father and son of Amercian Chopper fame illustrates the need to clearly delineate the terms of any option. (Paul Teutul v. Paul M. Teutel, 2010 NY Slip Op 09248 (2nd Dept. Dec 14, 2010))
The father and son had an agreement that included an option for the Paul, Sr. to purchase the shares of Paul, Jr. "for fair market value, as determined by a procedure to be agreed to by the parties as soon as practicable." Paul, Sr. sought to exercise the buyout option, which Paul, Jr. opposed enforcement of the option. The Appellate Court ruled that while the reference in the clause to "the term of 'fair market value' in and of itself may be 'sufficiently precise' ... the plaintiff and the appellant went further and expressly agreed to later agree on a procedure for determining the shares' fair market value." Significantly, the Court, quoting prior precedent, stated that for a closely held corporation (i.e.small prviately-held business) where ownership is held by a small group of shareholders and shares are not easily sold, the fair market value of the stock "'involves a certain degree of inexact valuation and subjectivity, making the procedure by which fair market value is determined of particular importance.'"
The Court reasoned that, as opposed to cases cited by Paul, Sr. where the parties had agreed on an (albeit flawed) procedure for determining fair market value of the stock, the clause here was simply an agreement "to later agree on a procedure for determining fair market value," and thus was not binding.
THE LESSON: The valuation of the stock/membership interests does not have to be determined at the time of drafting the option (buyout clause), but there must be clear terms as to the procedure for valuing the stock. One alternative is to identify a 3rd party, like a CPA, as the person who will determine valuation and perhaps agree to share the expenses of the valuation.
Subscribe to:
Posts (Atom)