Five Considerations When Structuring a Business

Drafting a business' operating, shareholders, or partnership agreement requires understanding parties' expectations and intentions, then expressing those concepts in an understandable and legally enforceable document.  There are basic default provisions that are common, and statutes that fill in any gaps, but every business relationship is unique and every agreement requires care and attention. 

Here are a few common considerations:

CONTROL

Decision-making authority can be a point of contention in any type of relationship.  In a business, we generally approach this issue by defining the scope of major decisions versus day-to-day matters, and then address each separately.  

The common presumption is of course that the majority owner has near-total control (subject to fiduciary duties and the minority owner's dissolution rights).  However, a minority owner can have a controlling vote on everything or anything; parties can agree that everything must be by majority or unanimous; decisions can be divided into spheres of influence; or you can have nearly any other arrangement you can imagine.  

Different business types have different statutory defaults.  In a partnership or some LLC's, every partner or member can presumably act independently and bind the business in day-to-day matters without the knowledge or consent of the other members.  By contrast, in a corporation, the shareholders have no authority beyond electing a board, which then appoints officers, who manage the day-to-day operations.  

How to approach the issue of control is often driven by the practicalities of the business relationship.  Frequently, for example, one party controls the checkbook and bookkeeping while another is in the "field" (or shop, or factory, or warehouse, etc.).  Other times, you can have a largely silent partner, who still needs to have access to information.  These clauses need to be clear enough to intelligibly reflect the parties' intent, but flexible enough to remain applicable as the business grows and develops.

CONTRIBUTIONS AND DISTRIBUTIONS

Capital contribution and distribution arrangements can vary widely, particularly where parties are providing different levels or types of contributions.  This is one of the most important areas where parties need a clear agreement reflecting their expectations, and can be one of the most common areas of dispute down the road.  

In a corporation, an owner buys their shares and owns the corresponding percentage of the company, with corresponding dividend rights, and a proportionate vote towards who sits on the board (and thus, indirectly, towards the timing and amount of dividends). These rights can be adjusted in a shareholders agreement, but are largely fixed, and represents the arrangement most people think of with respect to contributions and distributions. 

For partnerships and LLC's, the default statutory provisions basically recommend a written agreement, and impose a pro-rata distribution in the absence of one.  In a general partnership (as opposed to LP's or LLP's), capital accounts are maintained, and there are ongoing financial obligations. An LLC is something of a hybrid between a partnership and corporation, where membership "units" can be purchased similar to shares, but ownership percentages can effectively be subject to adjustment based on disproportionate future contributions in the absence of an agreement to the contrary.

Business owners need to decide, among other things: who contributes what; whether up-front money is a loan or capital contribution; whether there are obligations or rights to contribute further capital; and how non-monetary contributions are treated and valued.

DISPUTES

I often recommend a dispute resolution clause in any business agreement.  These can be as simple as requiring parties attempt an amicable resolution prior to litigation, either in the form of a "meet and confer" between themselves, or a non-binding mediation.  

A very helpful type of dispute clause requires parties to raise disputes in writing within a specified time period or else the issue is waived.  It is similar to the notice of claim requirement that protects municipalities.  The effect of such a clause is to limit any litigation to narrowly defined issues.  The risk, however, is that legitimate claims can be waived.  Accordingly, these clauses must be carefully crafted, and understood by the client.

Arbitration clauses have positives and negatives.  They arguably streamline litigation, particularly discovery, which can save money.  At the same time, you are paying private arbitrators, which can negate or exceed any cost savings.  Some attorneys will argue that selecting a business-savvy arbitrator has benefits, but in New York our Federal judges are exceptional and the State courts in Nassau, Suffolk, and the City have specialized commercial divisions.  

The major difference between judicial intervention and arbitration is the degree of discretion given to the arbitrator.  Not only does the arbitrator replace the jury in finding facts (if applicable), but they are also not bound by the law in the same way as a court.  

Attorneys-fee clauses can be very helpful, and I generally recommend them in business agreements, but it is something not every client will want.  Commercial litigation can be costly.  The ability to shift fees helps make an injured party whole, and can discourage parties from trying to use litigation cost and delay as a pressure tactic to renegotiate.  At the same time, however, there are situations where such clauses are not advisable.  For example, a majority-owner with substantially greater resources than the other party or parties may not want such a clause, as their risk would be disproportionate to the benefit to them.

LIMITATIONS ON TRANSFER

How and under what circumstances a business owner can transfer their ownership interest is an important consideration for small businesses.   

In some situations, the concerns are financial.  There may be anticipated rounds of capital financing that can be negatively effected by a rogue party selling their shares outside of the common plan.  Even when formal financing rounds are not anticipated, it is not uncommon to want to impose limitations on sales so as to protect the value of the business.  

The more common scenario relates to control and the practicalities of running the business: each small business owner wants a say in who their partners are, but also wants the ability to exercise their judgment in selling or transferring their own interest.  

A right of first refusal is a common solution, but every situation is unique.  Another option is a conversion from voting to a non-voting or limited-voting interest upon transfer. 

These clauses are tailored to the unique situation of each business-owner.

DISSOLUTION AND WIND-DOWN

Business owners going into a new venture are not thinking about dissolving it, but their attorney needs to. 

Clients should consider when an involuntary dissolution is permitted.  I have seen agreements that require a unanimous vote to dissolve (which is potentially unenforceable and a generally bad idea).  By default, owners of more than 20% of a corporation, or any member of an LLC or partnership, can ask the court to compel dissolution.  Absent a majority vote,  the court is not required to compel dissolution in the absence of oppressive conduct (in the case or a corporation) or the inability to continue an LLC as a going concern.  The default arrangement can, in some circumstances, give too much power to minority owners to start an action, and in other circumstances can leave minority owners stuck in the business (if they are treated fairly and the business can act without them). 

A buy-out option, and price (or method for determining price) is also an important consideration.  This can also shift over time (such as a buy-out at the buy-in price for a set period, and thereafter based on a valuation formula). 

As a practical matter, when the business is wound down, in the absence of a voluntary agreement, the judicial-imposed method is the appointment of a third-party (at a cost of up to 5% plus expenses, including legal), or letting the parties fight amongst themselves.  Depending upon the type of business and the parties, the process for wind-down can also be tailored to the specific business. 

CONCLUSION

The above are five of the major considerations when structuring a business, but there are many others. A single-owner business can be relatively easily and inexpensively he set up.  An attorney can be helpful, and is a valuable resource to develop as your business grows, but is often not necessary. Once a business grows to the point that there are multiple owners, despite many small business being very successful on what are essentially handshake agreements among the owners, professionally drafted organizational documents become even more advisable.