State business laws provide basic rules for the operation of business entities. But these are merely defaults. Owners of a business entity can enter into agreements with each other to address any of these default rules, or to create entirely new rules and relationships as needed. Typically the major operating rules are set out in a single agreement signed by all the owners—a partnership agreement in general and limited partnerships, a shareholders agreement in a corporation, and an operating agreement in an LLC.
One of the benefits of preparing operating documents is that it forces owners to discuss topics that are either easily overlooked or unpleasant to consider at the outset. Is everyone going to own the business equally? How often will we take earnings out of the business? What if we disagree on a major decision? What if someone wants to quit or sell their ownership? If the business closes down, how is that handled? These issues may not be at the forefront of people’s minds when starting a business but addressing them early can prevent disputes and misunderstandings down the road.
Below are several common issues that are often addressed in operating documents, but this is far from an exhaustive list and an attorney can help with additional issues that apply for a particular business.
Decision-Making and Management
The most common provisions in an operating document will relate to how the business is operated. For example, does everyone have to agree on everything? What if there is a deadlock among the decision-makers? An operating document can also create specific divisions of responsibility. It may assign each owner/operator the power to make decisions in their area of expertise—consider the an LLC with three members, where one member makes the decisions about the services offered, one member makes the decisions on finances, and one member makes the decisions on marketing.
Certain decisions might also be made jointly by majority vote, and there may also be a list of major decisions requiring unanimous approval, like admitting a new owner, taking out a large loan, making an acquisition, buying real estate, or deciding to sell the business.
The operating document could also delegate responsibility for management to officers. In the LLC example, the first member could be CEO, another would be CFO, and the third would be a CMO. Because the officers have the power to make the relevant decisions for the entity, each person would have the freedom to run their respective area of expertise.
In a corporation, a shareholder’s agreement can eliminate the board of directors and provide for direct management by shareholders. This reduces the overhead and formality of traditional corporate governance which makes using a corporation easier for small businesses.
Distributions
The basic purpose of a business is to make profits for the owners. But if a business is operating properly, it should have its own bank accounts and business funds should flow there. How does that money get to the owners?
Owners who are actively working in the business may take a salary. Both active and passive owners may also receive distributions of profits from the entity. However, most business entities are not required by default to make these distributions until the business winds up. It is up to the owners to decide how much to distribute and when.
To handle this, operating documents may include a provision that distributions will be made on a monthly, quarterly, or annual basis, assuming the entity has the cash to do so. It is important that owners get on the same page regarding distributions before significant business starts coming in.
Mandatory distribution provisions are even more important in pass-through entities because owners can face substantial phantom tax bills if the business makes money but doesn’t distribute it. For this reason, pass-through entities often provide for periodic tax distributions, which are calculated as the estimated tax obligation of each owner based on their ownership percentage, allocated profit, and effective tax rate.
Ownership Types and Classes
A limited partnership has two types of owners, the general partners and the limited partners. But a corporation or LLC by default only has one class—common stock in a corporation and membership interests in an LLC. Either of these entities can be organized with two or more different types of ownership.
In a corporation this would consist of common stock with one or more classes of preferred stock (this is where the traditional venture capital funding round names come from—in a Series A round the company is issuing Series A Preferred Stock, in a Series B round the company is issuing Series B Preferred Stock, etc.). In an LLC, this can either consist of specific rights for identifiable members, or where membership is denominated in units, multiple classes of units. Each class of ownership interest can come with different rights.
One common use of multiple classes of ownership interest is providing distinct power to control the business and how it is run. Some may carry supervoting powers, which can be used to allow certain people retain control of large publicly traded corporations. For example, Warren Buffet owns supervoting Class A shares in Berkshire Hathaway, allowing him greater control compared to his overall ownership percentage. A class of ownership interest can also have no rights to vote or participate in running the business. This type of ownership interest can be useful for compensating employees with equity, because it allows the employee to participate in the financial upside of the business while the owner retains full control.
A particular class of owners may be entitled to appoint a member of the business entity’s board. This is commonly seen in venture capital financing, where the lead investor negotiates the right to appoint a director (or directors) of its choosing. A class of ownership interests may also get certain specific rights to approve certain company actions, for example a right of first refusal to fulfill a future funding round.
A second type common use of multiple classes of ownership interest is to grant some preferential financial treatment to a class of owners. By default, all owners get a share of profits equal to their percentage of overall ownership. This can be altered by creating a second ownership class that has the right to receive a greater percentage than another class. For example, a corporation could have preferred stock that receives twice what the common stock receives when dividends are issued. A class of ownership may be entitled to a rate of return on its’ investment. For example, an outside investor may receive a special class of ownership interest that requires the business to return the investor’s capital plus six percent on an ongoing basis before allocating profits to the other owners.
A class of ownership interest can also be assigned a liquidation preference. A liquidation preference means that the class gets paid a multiple of the capital it invested when the business is sold or winds up. For example, a company may have a class of preferred ownership interest that it gave to an investor that says the investor receives three times its original investment when the company is sold before any other owners get anything. Having this liquidation preference limits downside risk if there is a low-value exit, but it can also cap a return if there is a high-value exit. For this reason, some preferred ownership classes will also participate in sharing the remaining proceeds—in a corporation this is known as “participating preferred stock.” Holders of participating preferred stock could receive twice their initial investment when the business sells, and then share any remaining sale proceeds with the rest of the owners.
While these are the most common uses, ownership classes are creatures of contract. This means that their capabilities are only limited by the creativity of the businesspeople and the relationships they want to engage in. Experienced legal counsel can assist in crafting appropriate rights, preferences, and obligations.
Minority Owner Protections
Most businesses are not owned equally among owners. Often there will be a minority owner, or an owner who can always be outvoted due to owning a small amount of the business overall. When things go well, a minority owner may not have much to worry about. However, due to the lack of control a minority owner may want to protect themselves from abuse by the majority owner(s). Most operating documents will already provide that certain fundamental decisions require unanimous or super-majority approval by the owners. Typical examples of these decisions are things like selling or merging the business, admitting a new owner, raising outside capital, or shutting down and liquidating the business. A minority owner may request other decisions be added to this list, such as approval for debts above the ordinary course of business or buying real estate. Sometimes, operating documents will include drag-along or tag-along rights that trigger when one owner wants to sell their ownership interest.
Transfers of Ownership
It is very common that one or more owners may want to sell their interest in a business entity. They may want to retire, pursue other business opportunities, or simply no longer want to be involved in the particular business. Operating documents will frequently contain restrictions or guidelines for transferring interests which can vary depending on the reason for the transfer and the intended transferee.
In many small businesses, it is common to see a blanket restriction on transfer. This means that, unless all the other owners consent, an owner cannot transfer their interest in the business entity. It may sound harsh but it’s actually quite helpful. In a small business, the owners have a strong interest in choosing who else they want to work with in running the business. A stranger coming in after buying out one owner may have a detrimental effect on the business, so it makes sense to give the other owners a right to approve their new co-owner.
Other common features may include a right of first refusal for any transfer to someone who isn’t an owner already, drag-along or tag-along rights, or a buy/sell provision to break a deadlock among owners. The operating documents may also govern what happens when an owner’s interest in transferred involuntarily, such as a result of divorce, bankruptcy, and death. These provisions can prevent a hostile ex-spouse, greedy creditor, or clueless heir suddenly being a co-owner.
Indemnification
Litigation among businesses is common. Unfortunately, a business owner may find themselves being sued personally in a matter related to their business. Defending a lawsuit can be extremely expensive and unpleasant. For this reason, most operating documents will include that the company will indemnify its owners, and typically directors, managers, or officers, in any lawsuit brought against that person related to their actions on behalf of the business.
This is just a sampling of matters that can be addressed in operating documents for a business. Our team of business attorneys can document the unique set of relationships in your business.
