Andrea and Susan were old friends who decided to start a small business together in Montana. For them the process of setting up their business was fairly simple; they found a great downtown location for their little gift shop, each invested a small amount of their own money to purchase inventory, and then they were open for business.
Initially they did not form any separate entity, but within a few months of opening they decided to form a limited liability company, or an “LLC.” Andrea found the “Articles of Organization” form, and filed it with the Montana Secretary of State. Over the coming months, both owners would use personal funds to help purchase inventory, in amounts they agreed upon, but they never formalized any agreement regarding using personal funds for the business.
After several years of being in business, Susan decided that she wanted to spend more time traveling and no longer wanted to be involved in the business. At that point in time the gift shop had become quite successful and Susan believed that her interest in the company had become very valuable. With that in mind, Susan approached Andrea to let her know her intentions for leaving the company and suggested that Andrea buy her out of the business.
However, the amount suggested by Susan was shockingly high to Andrea. According to Andrea, Susan was only entitled to her initial investment, which was less than one-third the amount proposed by Susan. Andrea suggested a lower price and unfortunately the two spent the next year arguing over the value of Susan’s interest.
This situation is all too common for small businesses; the owners file a form to become a separate entity such as an LLC or corporation in an effort to protect themselves from personal liability, but fail to actually follow the formalities of a separate entity and fail to execute an operating agreement. The operating agreement is key in determining the value of the business, how individual owners may join or withdrawal from the business, and what happens to an owner’s interest in the event of their untimely death, bankruptcy or other life event.
Observe Business Formalities
First, observance of LLC or corporate formalities is an important factor in determining whether it will be actually treated as a separate entity. If the LLC or corporation is not treated as a separate entity, then the members or shareholders may be held personally liable for the debts and obligations of the company.
Some examples of how to maintain business and personal matters separate include:
Refrain from commingling business funds or accounts with personal funds. If you are placing personal funds in the business, make sure it is accounted for as a capital contribution, a loan or a reimbursed expense.
Always make clear when you are acting on behalf of the business, rather than acting in a personal capacity. This may include signing documents in a representative capacity or clarifying your role in a business meeting.
Do not use funds owned by the business to pay personal debts and obligations. Personal obligations should not be paid directly from business accounts. If you need to make a personal payment, pay yourself first as a member or shareholder of the business, then make a payment from your personal account.
Maintain written documentation of actions of Members, Shareholders, Directors or Officers. This includes maintaining minutes of your annual meeting and any special meetings, or written consents, signed by all owners.
Create an Operating Agreement (or Shareholder Agreement)
An operating agreement is the document used by the owners or “members” of an LLC. A shareholder agreement is the document used by the owners or “shareholders” of a corporation. For discussion purposes the term “operating agreement” is used here to generally discuss internal documents for the operation of various business types, but a different term may be used for a different type of entity.
An operating agreement is a contract between the members of the LLC and the LLC as a separate entity. It sets out all of the internal terms for the operation of the LLC. These terms may include valuation, distribution of profits and losses, and the withdrawal or addition of a new member.
While an operating agreement may be drafted by an attorney, it is important the members or owners of the business have a discussion as to the important points of the operating agreement. This ensures everyone is on the same page and has discussed these issues from the beginning of the business, rather than trying to figure out these issues in a disagreement or other unknown circumstance.
Some important issues to discuss in the creation of an operating agreement include:
What limitations to place on transfers of ownership. Some options to consider include: no transfer without consent of all owners; right of first refusal of company and/or members; limitations on forced buy-outs; or right to remove owners for certain unlawful or unethical actions.
How to fund a buy-out of an owner. Consider such issues as allowance for installment payments, use of life insurance, or loans.
How to calculate the value of an ownership interest in the business. Will the value simply be book value, or assets minus liabilities of the company? Or do you want to use a different formula? Do you want to set a price in advance?
What happens in the event of unforeseen life circumstances? What happens to an owner’s interest in the business when that individual owner retires or wants to withdrawal from the business, becomes disabled, gets a divorce or files for bankruptcy?
Obviously these are just some of the discussion points to consider when creating an operating agreement. A business attorney can advise you on options for your particular business. However, it is important that the business owners discuss these issues prior to starting business, rather than wait until after a dispute arises, like Andrea and Susan.
If only Andrea and Susan had taken some extra time to create an operating agreement when they started their business, they could have spent less time and money arguing back and forth over the value. Instead Andrea could have spent more time focusing on the business and Susan could have spent her time traveling. By taking the time to discuss a potential buy-out in the beginning of their business these women could have saved themselves significant time and money in the long-run.
For advice regarding business formalities, operating agreements or general business law contact Measure Law at 406-752-6373.
Measure Law attorneys provide expert legal advice with regard to Business Planning along with Real Estate Law to help protect you grow your wealth while protecting your assets. See our Practice Areas page for more details.