LLC & Partnership Agreements: 5 Top Issues
Disclaimer: The following information does NOT constitute legal advice and is only for general educational purposes. Each situation is different and specific legal issues usually require additional research and investigation, so do not rely on this article to address a particular legal issue; use this as a starting point to gain a general understanding. This article, although educational in purpose and substance, nevertheless, might be deemed attorney advertising, and prior results do not guarantee future success.
When starting a business, you should discuss your rights and responsibilities with your lawyer and associates and have a clear agreement. Again, this a more simplified article, but feel free to go in depth here and here.
1. You Have Nearly Unlimited
Flexibility in Your LLC/Partnership Agreements
Did you know you can custom design nearly all the rules of your own partnership or LLC with nearly unlimited flexibility? I say nearly, because some things you might try and do could be against public policy, regulated by the IRS to prevent fraudulent transfers or just "abusive" in the eyes of the law (in legalese there are fancier terms like "you can't make someone else responsible for your negligence" or "abdication of fiduciary responsibility"). However, you can determine things like, if you contribute your time, and I put in $10,000, we each get 50% of the future profits. Or we each are entitled to 50% of all company assets and profits (meaning you get half the $10,000 if we dissolve). Or, I loan the company $10,000, and we each put $0 in, and if we make any net profits, the company pays back the loan first, and then we split everything 50/50. or 40/60. Or 50/50 for the first five years, then 40/60. Whatever we want! (although again, there might be IRS implications for some of these).
2. If You Don't Decide the State Will
If you don't address key issues in your LLC or Partnership Agreements, the State of your formation / incorporation / organization probably will. Every state has default rules for many of the key issues that will affect your ability to run your company vis-a-vis your partners? For instance, if you don't decide who gets what, who owns what, who is responsible for what, these default rules will take over, and you will have lost your opportunity to control your own destiny. I mean, if you don't want to decide what's best for yourself, why are you even in business? The state rules might not be what you always expect. For instance, in New York State, in an LLC, voting power BY DEFAULT is determined by Profit Interest, which BY DEFAULT is determined by capital contribution. Meaning, you put in $10,000 and I put in $10,000, we each are entitled to 50% of the profits and we each have 50% voting rights. However, what if you are working 50 hours a week and I put in $10,000. Absent an agreement, theoretically, you are entitled to zero although a court is likely to see what we agreed orally, or at minimum insist you receive some kind of quantum merit reimbursement. However, those are all weak arguments that are difficult to prove. Isn't it easier, just to spell it out on paper and avoid later misunderstandings? Better to return back to the land of wage-slaves, no? That way your manager can decide everything for you.
3. Who's in Control?
Who is in charge of the decisions? Does each Member or partner have equal say? Or will you follow the default rules of many states and allocate voting power by contribution of capital or profit interest? Can some partners make certain decisions? For instance, in a restaurant with three partners, John the chef has total control over the menu, Jane the CFO has total control over purchases up to $10,000 and can generally pay bills or commit to any single contract under that amount, and Harry who contributes labor has no control over anything except that Harry may not be required to work more than 40 hours a week without additional compensation to be negotiated with Harry and Jane. In LLC Operating Agreements and Partnership Agreements you can do this easily with *nearly* total power to allocate power and decision making as you see fit. Again, there might be some minor restrictions.
4. How Should You Split Profits?
This sounds simple enough but is it? I contribute my time, it's your idea, and our friend is putting in a lot of money. Do we split profits three ways? Does it depend on how much money our friends is putting in? What about losses. Companies often lose money in their first years, did you know that? Losses are valuable resources. Huh? They can be deductions for someone making money somewhere else. We could split the money 30/30/40 and give 100 percent of the losses to our friend for the first few years. Or whatever we want. Although you should speak with your accountant to ensure there aren't unforeseen tax consequences.
5. Can You Ever Leave?
Breaking up is hard to do. Depending on your agreement and the default state laws of formation/organization, you could be locked in forever to your current company unless everyone agrees to leave, sell it or shut it down. A good agreement will address what happens if someone wants to leave: can they force their fellow members / partners to buy them out? What if someone gets an offer to buy them out? Can you demand you be bought out as well ("tag-along" provision). Or, can you force everyone else to sell ("drag-along" provision). What if someone marries or moves? Do they get special treatment to leave? State laws in this regard can be a very ugly surprise if you don't know what you're doing and don't plan for it. Be sure you know what you're getting into.