Business people: If you are regrouping to take your business to the next level, your form of legal entity and your company documents can be a help or a hindrance. This may be a good time for a check-up, and perhaps a tune-up, of your business structure and operating agreement.
This article is based on real world situations that I see confronting businesses in Illinois and in Texas. The businesses typically are organized as limited liability companies (LLC), a good business structure for small and mid-size companies. Many of the same principles apply to other forms of business entities and in other states.
Small and mid-size companies need IP and business
We represent many small and mid-size businesses that actually make and sell a product, which can range from industrial goods to consumer products to software. They typically employ engineers or coders to invent still better products to satisfy customers’ needs. They often come to us for intellectual property (IP) protection that will help them gain and keep market leadership, sales, and profits. The IP assets—patents, trademarks, trade secrets, copyrights—add to their capital valuation and attract investors and sometimes buy-outs.
IP is important but it isn’t everything. Business clients come to us for IP and they stay for a broader range of business-oriented legal services. What we find is that many companies need attention to their basic legal set-up and documents. In this article, I will focus on the LLC operating agreement and leading reasons for amendment. Other business agreements also are important and they often can benefit from legal review and revision.
Business success and growing pains
You might see yourself and your business in in this situation. You’re innovating. You and your product are better than the competition. You have revenues and cash flow. That’s all good!
Now, to take and keep the lead in your industry, you must make your product even better. It’s time for version 2.0. And this time you want to patent the improvement. That takes money.
So you’re negotiating to bring in another investor. Or a key salesperson.
But there’s a catch. They want a stake in the business: ownership (if they invest) or a share of the profits (if they grow the business).
Your company agreement might need some work
One might think that most people have set up their businesses properly. Not so! Mistakes are common.
The good news is that the sooner issues are identified, the sooner they can be fixed.
A limited liability company (LLC) is often a good choice of business structure from startup through maturity. It’s fairly simple and flexible and it can provide for favorable tax treatment. If set up properly, it can make the business attractive to investors and key personnel. Other structures can be considered, such as a sole proprietorship or an S or C corporation.
Let’s say you formed an LLC some time ago. Do you have a good operating (or “company”) agreement in place?
The operating agreement can and should set ground rules for ownership and management. It’s tempting to gloss over those words, but let’s dig a little deeper. By ownership, I’m talking about investment. If it’s your company, you have invested money, blood, sweat and tears, and you’d like to protect that investment and see it grow. You also may want to attract other investors and key personnel. Your current LLC operating agreement should, but may not, be a good vehicle for those valid purposes. As for management, well, somebody has to run the company, and that somebody might be you. Does your operating agreement give you the authority to run the business?
The operating agreement also can provide for accounting and tax considerations. It can set the rules for how a member withdraws, e.g., whether, how, and to whom they can sell their shares. It can insulate LLC members from some financial liabilities. It also can provide the terms for how amendments are to be made.
Operating agreements are commonly amended. Just as businesses find it necessary to change direction, so should agreements be amended to keep up with the current reality and to provide for intended growth.
From a growth perspective, a good operating agreement can help make your business attractive to investors and key employees. And if amendment of the agreement will help you accomplish your goals, amendment should be considered.
Two common oversights in LLC setup
Among other issues in the setup of an LLC, these two are common:
- Picking the right company name and clearing and protecting it as a trademark; and
- Choosing the right form of management for the company.
We’ll address each of these issues in turn.
1. Selecting the right company name/mark
When you started your business, one of your first choices was to pick a name for the company. You are not alone if you made a less-than-optimal choice of company name. In fairness, there’s more involved than first meets the eye, and it take a combination of business, legal, and IP thinking and action to select and protect a good name for the company.
Most startups pick a name that isn’t distinctive. Or one that fails to suggest their line of business and their unique selling proposition. The former error makes the company name hard to protect; the latter can make the name less valuable to your business than it otherwise might be.
Many business owners think that just because the Secretary of State (in your state) agreed to register the company name, it must be cleared and protected, i.e., as a trade name or trademark. That’s logical, but incorrect.
A company name is a trade name, and it’s usually also used as a trademark or service mark. Marks should be cleared before they’re used, and federal registration in the U.S. Patent and Trademark Office should be strongly considered for several reasons including deterrence of knock-offs.
Most likely, your business has evolved into something different from what you first planned, so the company name might need tweaking anyway.
Now may be an opportune time to clear a company name/mark properly, and to file for a federal trademark registration. If you select a new name, that should be reflected in an amended operating agreement and the State may need to be informed.
2. Choosing between member control and manager control
When you started up your business, you faced this question: Who runs the business?
A common choice is a member-managed LLC. That’s usually the default under the laws of most states. But management by all the members is difficult to accomplish. It can be hard to get everyone together to make decisions, let alone to reach consensus. Quarrels can occur, and the business can suffer from paralysis.
A manager-managed LLC sometimes works better. It’s especially appropriate when one person puts in most of the capital and takes most of the responsibility for running the company. It also tends to be the reality. Even if other investors own the majority of the stock, someone—often one person, and it might be you—needs to run the company, and especially to make the day to day decisions. (Under the terms of the typical agreement, owners also can change the manager.)
If you’re the manager, does your operating agreement give you the power to hire and fire? Does it give you the authority to negotiate and enter into business agreements with customers and vendors? Does it allow you to buy and sell equipment and furniture? To pay the bills?
Here’s what often happens. The LLC operating agreement might say that the members (or some majority of them) have to agree on everything. The reality often is that a manager just does what needs to be done. This is a recipe for conflict, either now or down the road.
The choice of control—typically either by the members or by a designated manager—along with many other choices in the setup and operation of the LLC—should be documented in the operating agreement. If the agreement doesn’t match the reality, one or the other should be amended. (A legal agreement may be relatively easy to revise, as compared to changing the reality of the way a business operates.)
Put agreements in writing, get them signed, amend as needed
Some people try to make the operating agreement do too much of the work. Some of the details are better left to employment agreements, buy-sell agreements and the like. Covenants not to compete might be appropriate, depending on the situation and the state. Non-disclosure agreements (NDAs) and other provisions concerning intellectual property ownership and assignments can be critical to the health of the company. Purchase orders and purchase-and-supply agreements all have the power to bolster or to detract from your bottom line and your assets.
Benjamin Franklin, who retired from business at the age of 50 to devote the rest of his life to science and government, attributed much of his success to clear written agreements with business partners. He had an out-of-state partner before the advent of the Internet. If he could document and conduct a national business, you can too.
Do your legal documents match the reality of what your business has become? Your documents should reflect how the company is actually owned and managed.
Does your LLC operating agreement provide the flexibility needed for your current and anticipated needs? If there is a gap, it might be appropriate to amend the documents to match the reality and the intended direction of the company.
In the absence of good, written, signed agreements, disputes between members can create a crisis, and the result might be determined by defaulting to your state’s laws. Such determinations can be imposed by a court. And that might not be pretty.
Why it matters
Well thought-out and carefully tailored agreements can help your business succeed, attract and keep investors and key employees, and minimize squabbles now and down the road. If your business has changed, or if you are planning to change, you might benefit from review and amendment of your documents including your LLC operating agreement.