Start-Up Basics, Part 2 – The Importance Of Being In Agreement

By: Brian J. Meli

This is Part 2 of a two-part article on the legal basics of starting a business. Part 1 can be read here

The last time around, we discussed some of the ways to turn a promising new business idea into a real live commercial entity. Now let’s assume you’ve selected your business form, registered it (if necessary) with the appropriate governing body of your home state, and taken all the other incidental but necessary steps to achieving businesshood. Now what?

First, congratulations. You’re official. Savor this moment. But not for too long, because while taking that metaphorical leap into business legitimacy is a momentous emotional step, it’s really just the first on the path to legally protecting your business interests. If you’re like most new business owners, you’ll be tempted to put the paperwork behind you at this point and start focusing all your energy on the business itself. But resist that urge, because the legal issues of starting a company aren’t behind you quite yet.

If you filed formation documents with your home state, those documents essentially formed a contract between you and the government (the state promised to formally recognize your business entity and afford it all the protections that go along with that, and in return, you promised to abide by the state laws governing that entity). With that complete, the next step is to put in place a contract between the owners of the new company itself, governing their rights and duties with respect to one another. If you formed a corporation, that contract will be called your bylaws. If you chose an LLC, then its called an operating agreement. If it’s a partnership, it’s your partnership agreement. For the sake of simplicity and ease of illustration, we’ll refer to all of these documents generally as “partnership agreements,” but no matter what your specific agreement is called, it will serve essentially the same purpose: to establish the legally enforceable rules by which your company will be managed and governed.

These agreements answer the difficult questions that every business owner must ask his or herself as early as possible. Questions like: what happens if my partner and I disagree on an important company decision? What happens if another owner wants to dissolve the company? What happens if one of the owners dies or becomes incapacitated? What happens to my business if I get divorced? And so on and so forth. The amount of possible questions is really only limited by an inquirer’s ability to contemplate potential future scenarios.

A helpful way to think about these agreements is to compare running your new company to sitting down to play a game. The partnership agreement serves as the rule book for the game. Since you’re an owner and this is your game, you and your fellow players (partners) have lots of discretion about how the rule book will read. Ask any six year-old though, and they’ll tell you that playing a game where the rules are made up as the game progresses, or with rules that keep changing at the whim of one player, is fundamentally unfair. This is especially true in the real world, where unfair businesses are dangerous ones, and where there’s a lot more at stake than just hurt feelings.

It isn’t the act of making up rules that’s the problem. At some point the rules of every game had to be made up. What makes rules unfair is the inability for all players to fully understand and agree on them ahead of time. Therefore, it’s essential for all interested parties in a company to be on the same page from the very beginning. Because without prior agreement there will be surprises, and among partners, surprises lead to conflicts, which are universally bad for business.

If surprises are the enemy of a healthy, well-functioning small business, then the surest way to dysfunction is to leave your rule book to chance. In the absence of a partnership agreement, your hard-fought company will find itself subject to the arbitrary default provisions of your home state. And while most small business owners wouldn’t dream of voluntarily leaving the fate of their company up to state lawmakers, a company without an agreement in place is doing exactly that.

A common mistake is to think you don’t need a partnership agreement because your company doesn’t have any profits. The truth is, though, that profits aren’t a prerequisite for disputes because, absent an agreement to the contrary, owners are just as equally liable for liabilities as they are entitled to surpluses. So if you’re incurring debts in the name of a company with multiple partners, you’ll want to make sure you’re sharing that financial burden in a way that’s mutually agreeable.

Another mistake is to rely on canned partnership agreements downloaded from the Internet. Let me be clear that there is nothing inherently wrong with these types of agreements. Some of them are actually quite good. But these forms shouldn’t be mistaken for anything but useful starting points. Typing your company name into a generic template and relying on it to serve as an effective partnership agreement is akin to buying a picture frame and putting it up on your wall with the stock photo still in it. The agreement itself is just the framework, around which the rules governing your business must be fleshed out, and this requires the know-how of a professional with the experience to understand the different types of provisions you’ll need to accomplish your goals. Otherwise, you’ll be hanging a picture of strangers on your wall.

There’s really only one good excuse for not executing a valid partnership agreement as soon as you’re open for business. And that is if you don’t have any business partners. If you’re truly a lone wolf, then it isn’t critical to have a formal agreement in place at the outset, but even so, it may be in your best interest to do so at some point. New ventures notoriously require lots of outside help, whether it be in the form of consultants, financiers, advisors or anyone else whose expertise and/or capital may be required to get your fledgling enterprise off the ground. And just because you don’t view someone you’re working with as a partner doesn’t mean they see it the same way. The story unfolds in many different ways, but every version has same theme: someone helps a struggling entrepreneur out in her time of need by lending her his time, money, ideas, or just friendly advice, and later, when the venture takes off, the good samaritan shows up looking for his percentage. It happens all the time. Just ask Mark Zuckerburg. But it can be prevented more often than not with a well-drafted partnership agreement tailored to the unique circumstances of your business.

It may take a little extra time, and a little more money than you’d initially planned, but making sure that all the stakeholders in your new business are in agreement and playing by the same rules right out of the gate is an investment that will ensure the long term stability of your company like no other single document ever will.

The content of this blog is intended for informational purposes only. The information provided in this blog is not intended to and does not constitute legal advice, and your use of this blog does not create an attorney-client relationship between you and Brian J. Meli. Under the rules of certain jurisdictions, the material included in this blog may constitute attorney advertising. Prior results do not guarantee a similar outcome. Every case is different and the results obtained in your case may be different.

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