Creating a clear-cut ownership structure

In my career as a corporate consultant and mentor to start-up accelerator companies, I can say that, without a doubt, the most common reason for a new venture to fail can be boiled down to discord among the partners. The thing is, starting a new venture is exciting … especially that initial idea phase, where you start painting a picture of the brilliant future that awaits you and your partners.

Usually it transpires somewhat like this: A few friends are together and one has a seed of an idea. He tells his buddies and then it steamrolls. Ideas are excitedly thrown into the mix, some are tossed, and others are kept — until a rough blueprint for a business model has been fleshed out. Sometimes this happens over a few hours, and sometimes the process takes months. Regardless, when a plan finally comes together, everyone is excited to jump on board the moving train. It’s usually at this stage that most failed startups set up their eventual demise.

Here’s the rub: Everyone is equally excited, and everyone took equal part in the business planning, so everyone should share equally in the ownership of the business, right? Wrong. Business ideas don’t hold much value — they aren’t even patentable — it’s the execution of those ideas that matters. That is where the ownership needs to be distributed. You need to take an accurate count of what every owner will be contributing and then structure the ownership of your LLC to support those contributions. You need to have built-in safeguards for accountability — in other words, if a partner doesn’t deliver what she promised, she doesn’t get the membership shares.

In Chapter 10, I show you in detail how to structure your partnership in a way that keeps folks honest. But for now (if you have partners), you need to keep in mind that this is one of the core functions of your operating agreement.

LLCs can have different classes of membership, so all members don’t have to be treated the same. Some members can get voting rights while others have to remain silent. Some members can also be managers and take charge of the company’s day-to-day operations, while others can only watch from afar. Also, some members have certain powers that are inherent to owning the company, such as deciding who manages the LLC and whether to accept new members. I go over membership-related topics in detail in Chapter 10.

Assigning manager titles and duties

Regardless of whether your LLC is manager-managed or member-managed, the managers need boundaries and guidelines. Even if you are the only manager and you want unlimited decision-making power, you need to allow for this in your company’s operating agreement. Some states require it by law, but regardless — it will keep you out of trouble when one of your non-managing partners contests that lease agreement you entered into or that building you purchased.

Forming your operating agreement is the perfect time for you and your partners to sit down and delineate all the specific roles and titles that each manager will take on. For instance, one manager may be great at numbers and will take on the role of chief financial officer, whereas another manager may have a solid vision of the company and is the person to lead the others on the path to success — this person can be named president or chief executive officer.

In certain situations, you may also want to consider adopting the “corporate” management structure for your LLC. This structure comes with the preset roles of President, Secretary, Treasurer, and Director. (Of course, since we’re talking about an LLC here, you can adapt those roles to your needs however you want.) One example of where this may be helpful is if you have an investor who wants the immediate tax deduction that an LLC can offer (assuming the LLC doesn’t bring in a profit its first year), but prefers the traditional management structure of a corporation. I show you how to elect a corporate management structure at www.dummies.com/extras/limitedliabilitycompanies.

Keep in mind that although managers are legally called managers by the state, they can have whatever titles they want. So, even if you don’t elect the full corporate management structure, don’t think you’re missing out on the title of president or CEO if you’re forming an LLC!

Formation and Qualification

This provision basically states that the members of the company all agreed to form the LLC under the laws of a particular state. If you have a formation date, you can include it here. If you haven’t yet received your filed articles from the state, then feel free to omit the date.

Here’s a sample provision that you may want to adapt to your needs:

On April 13, 2014, the members formed the LLC by filing articles of incorporation with the Secretary of State of Indiana in accordance with the Indiana Business Flexibility Act.

Name

Under the “Name” article of your operating agreement, you simply list the legal name of your LLC as it was formed with the state. Again, if you haven’t received your filed articles, you can simply list the name as it appears on your articles of organization. In the event that the state rejects your name, you and your partners can amend your operating agreement to reflect the new name.

Here, you may want to list any DBAs that your company intends to operate under or have a blanket statement that allows the members and/or managers to operate the company under DBAs in the future. You may also want to specify any rules for changing the business name. For example, who has the authority to change the name — the members and the managers? Or just the members?

Here is a sample provision that you may want to adapt to your needs:

The Company may conduct its affairs under the name ABC Trucking, LLC. Upon written unanimous consent, the members may change the company name or adopt one or more fictitious firm names (“DBA”s) for the company, to the extent permitted by law.

Term

Back in the day, LLCs were required to have a limited life span. Long story short, the IRS wouldn’t grant LLCs the benefits of partnership taxation unless they contained a few facets of traditional partnerships — namely, they can’t live forever. But as LLCs have evolved to become the business structure of choice, this requirement has been phased out. Unfortunately, traces of it still exist in some states’ laws.

For this reason, I strongly recommend that all LLCs have a basic statement stating that the company will exist perpetually until the members elect to dissolve it (the specifics of which are described in the Dissolution section of your operating agreement).

Here is a sample provision that you may want to adapt to your needs:

The Company will exist perpetually unless either a.) the Company is dissolved by the Act, or b.) the Company is dissolved under this Agreement.

Your company may want a limited life span. I go over this possibility in Chapter 6, where you would state such a desire in your articles of organization. If this is the case for your company, then you’ll want to make sure to state your duration in this section of the operating agreement.

Purpose of the Company

When friends ask you why you formed your LLC, you’re likely to give a somewhat specific answer, such as “I want to flip houses,” or “I want to sell bacon cupcakes to pet owners.” But when it comes to your operating agreement, you want to keep your purpose as broad as possible.

This provision should match the provision that you place in your company’s articles of organization that you file with the state (see Chapter 6). It should state something such as this:

The purpose of the company shall be to carry on any and all activities as may be lawfully conducted by a limited liability company under the laws of the state of Indiana.

Only under certain circumstances — which I go over in Chapter 5 — will you want to limit your company’s purpose.

Books and Records

Five years ago, this section would have made reference to the “company kit,” which includes a transfer ledger that is legally accessible by all members of the LLC. Technology is changing everything, and this is a good thing for members. No longer are all the vital company records stored in a single leather-bound kit, usually accessible only to the member who has physical custody of it. (You’d be surprised how many of these kits get “lost” when disputes arise.) Now, things are migrating online, and these important records are stored digitally by third-party companies and accessible to all members.

Most states’ laws are pretty firm on what information LLCs are required to share with their members. This rule often can’t be overwritten by the LLC’s operating agreement. In other words, you cannot elect to keep your members in the dark if they ask about certain key things. So before you decide to stray from the standard, you may want to check your state laws.

Here’s a sample provision if you’re using digital records:

The Members shall digitally maintain at www.docrun.com/ABC_Trucking (replace link with whatever digital corporate kit you’re using) the following records of the business: a current list of the full name and last-known business or residence address of each Member, together with their capital contribution and membership interest; a copy of the Articles and all amendments thereto; copies of the Company’s federal, state, and local income tax or information returns and reports, if any, for the six (6) most recent taxable years; and a copy of this Agreement and any amendments to it.

If you’re going with the traditional, leather-bound company kit, here’s a variation of the first sentence that you may want to use:

The Members shall maintain at the Company’s principal place of business the following books and records:

Financial Records and Reporting

This section gives members the right to inspect all the business’s financial records. It should tell them where the financial records are held and what sort of financial reporting they can expect as members. After all, as a member, wouldn’t you want to know what’s going on with your investment?

Following are a couple specific things you should include in this section:

• Accounting and the Company’s Fiscal Year: This provision states what the company’s year-end is and who the company bookkeeper or accountant is. Listing the name and contact information of your company’s accountant is optional. It’s not vital, but it may be nice to have, depending on your situation.
• Financial Reporting: It is common practice for the company manager to provide regular financial reports to the members. The types of financial reports to be provided (balance statements, profit and loss statements, and so on) and the frequency of distribution should be noted here.

It’s common to want to state in this section that certain financial reports will be e-mailed quarterly (or whatever time frame you agree on); however, I don’t recommend doing so. If something comes up and the company fails to live up to these promises, you could be opening the company up to liability with your investors or other partners. I recommend simply allowing these records to be inspected in person upon the request of an individual member.

Here’s a sample provision for LLCs that have partnership taxation and that report to the IRS on a calendar-year basis. Feel free to customize it as necessary:

• The complete and accurate accounting and financial records of the Company shall be held by the Managers at the Company’s principal place of business. Such records shall be kept on such method of accounting as the Managers shall select. The Company’s accounting period shall be the calendar year.
• The Managers shall close the accounting records at the close of each calendar year, and shall prepare and send to each Member a statement of such Member’s distributive share of income and expense — in the form of a Schedule K-1 — for income tax reporting purposes.

Who is responsible for maintaining the company’s books and records? Will one person be in charge of this task? If you have a larger company, everyone will likely go about their daily business and not have a care in the world about dealing with the random record-keeping tasks that come up. You may want to assign one person to handle everything; that way, someone is responsible for the job and can be held accountable if it isn’t completed.

Liability of Members

Although state law normally provides a default liability protection for the LLC’s members, it’s always good to throw in a provision that calls for it anyway. It doesn’t have to be lengthy. Here’s an example of a limited liability provision that you can use:

No Member shall be personally responsible for any debts, liabilities, or obligations of the Company solely by reason of being a Member. All debts, obligations, and liabilities of the Company, whether by contract or not, shall belong solely to the Company.

Indemnification of Members and Managers

Although all managers and members are provided a basic level of indemnification (a fancy word for limited liability), it’s always good to restate it in your operating agreement. Essentially, you’re telling the world that all the LLC’s managers, members, and employees are free from and not responsible for the obligations and debts of the company.

Now, this provision can be taken further. If you so choose, you can elect to have the company take complete financial responsibility for all the actions of any member or manager of the company made on behalf of the company — even criminal actions. This means that the company is responsible for paying not only any legal fees, but also any judgments that arise. This is often called uncapped indemnity in the legal world, meaning that there is no “cap” (or ceiling) on the amount the company is forced to pay in full defense of and in taking full responsibility for a member’s actions.

Except in some cases, such as a single-member LLC, I generally don’t recommend providing uncapped indemnity for all acts, including criminal ones. If anything, you may want to cap it (that is, cut off the funding) at a certain dollar amount or under certain conditions, such as “in the event of a misdemeanor.” Doing so protects your company (and its solvency) should one of your members do something shady in the name of your LLC.

Here’s a sample indemnity provision (excluding unlawful acts) that you can adapt as needed:

The Company shall indemnify any person, to the fullest extent permitted by law, who is a party defendant or is threatened to be made a party defendant, pending or completed action, suit, or proceeding, whether civil, criminal, administrative, or investigative (other than an action by or in the right of the Company) by reason of the fact that the person is or was a Member of the Company, Manager, employee, or agent of the Company, or is or was serving at the request of the Company, so long as the person did not behave in violation of law or this Agreement, for instant expenses (including attorney’s fees), judgments, fines, and amounts paid in settlement actually and reasonably incurred in connection with such action, suit, or proceeding.

Dispute resolution

Whenever a lot of people get together and work on a project for an extended period, disputes are bound to come up. Often, they come out of nowhere, blindsiding you at the worst times. Unless they are dealt with properly, they can seriously harm your business, and resolving them can take time and precious resources that your business needs to grow and prosper. To prevent these situations from happening, you and your partners should be forward-thinking enough to add guidelines on how to deal effectively with disputes when they come up.

First, you should specify the state in which disputes are to be dealt with. Handling lawsuits and disputes in states other than the one in which your company headquarters is located can be incredibly expensive. And even then, a court may not allow a lawsuit to be filed in a jurisdiction other than where the transgression took place. Therefore, a great policy is to require that all members take legal action only in the state in which your company is located.

Second, you’ll likely want to keep your disputes out of the courtroom. Lawsuits can be costly and, at times, debilitating. You should provide your members with a means to handle their disputes in a friendlier, more laid-back way. Specifically, you’ll want to bind them to mediation and arbitration (a diplomatic way to handle disputes in which a third party hears both sides of the disagreement and then makes a decision about the outcome).

Here’s a sample provision that you can use:

• The Members agree that in the event of any dispute or disagreement solely between or among any of them arising out of, relating to, or in connection with this Agreement or the Company or its organization, formation, business, or management, the Members shall use their best efforts to resolve any dispute arising out of or in connection with this Agreement by good-faith negotiation and mutual agreement. The Members shall meet at a mutually convenient time and place to attempt to resolve any such dispute.
• However, in the event that a member dispute cannot be resolved, such parties shall first attempt to settle such dispute through a nonbinding mediation proceeding. In the event that any party to such mediation proceeding is not satisfied with the results thereof, then any unresolved disputes shall be finally settled in accordance with an arbitration proceeding. In no event shall the results of any mediation proceeding be admissible in any arbitration or judicial proceeding.