8 Reasons Why Your LLC Needs a Company Agreement

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Jane, Mary, and Alice have a thriving business. They decided to operate as an LLC and handled the formation themselves by filing a certificate of formation with the Texas Secretary of State.

Everything was fine until Alice got divorced, and her ex was assigned half her membership shares.

Who’d have known their company shares were community property!

Now, the ex is making life miserable by demanding to see the books, demanding distributions, and threatening to sue. What a mess: a mess that was avoidable. Had they adopted a company agreement, the owners could have managed what happened to the company shares in divorce.

A company agreement, also called an operating agreement, describes the way a limited liability company will do business. The company agreement governs the relations among members, managers, officers, and the company. Even a sole member LLC can, and should, adopt a company agreement. Here are a few reasons why.

 

  1. Retaining control. A company agreement allows the members to determine how the company is governed and what happens to membership shares if a member dies, divorces, files for bankruptcy, or just wants out. These kinds of events can erode members’ control over the business. It is best to deal with these contingencies before they happen. A company agreement does that.
  2. If you don’t have a company agreement, the State of Texas will set the operating rules for your company through Chapter 101 of the Texas Business Organizations Code. Many of the Code provisions can be waived or modified to better suit your company.
  3. With a company agreement, you can establish different classes of ownership. For example, a you may want to retain control of the company but give others a share in ownership. This can be accomplished by having two classes of membership: voting members and non-voting members. Without a company agreement, an LLC is limited to one class of membership.
  4. A member of an LLC cannot withdraw or be expelled from the company unless you have a company agreement that describes a process for a member to withdraw or be expelled. In other words, if one member wants to leave, or if members want to kick out a non-performing member, you can’t do it unless you have a company agreement.
  5. A company agreement can limit assignment of interests. What if a member gets into financial trouble and wants to pledge membership shares as collateral for a loan? If the member defaults on loan payments, you may up with a business partner you never intended to have.
  6. A company agreement can describe the relationship between members and managers. While the certificate of formation states whether an LLC is managed by its members or managers, there is no guidance or restrictions on managers without a company agreement.
  7. A company agreement can expand or limit the duties, responsibilities, and liability of members, managers, and officers. Many members are shocked that Texas law does not impose a fiduciary duty between them. A fiduciary duty is a duty of loyalty to act in the best interest of another. If you want members to owe a heightened duty to one another or to the company, you must have a company agreement.
  8. Having a well-drafted company agreement saves money in the long run. By fully describing expectations in a company agreement, members have a means of resolving disputes without resorting to litigation. The initial investment in legal fees for drafting a solid company agreement is tiny compared to the cost of arbitration or litigation.

 

A company agreement is a valuable tool that allows LLC owners to control the destiny of their company and to manage relationships between themselves, their managers, and their officers.

They can expand or limit responsibilities and liability as they see fit.

Adopting a company agreement early can be a cost saving strategy that staves off expensive problems later, and the agreement can be modified as the company grows. It is critical to use an attorney to draft a company agreement, but it is money well spent.

Writing it Down: 4 A Recipe for Writing Simple & Personal Agreements

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My last post explored common problems with handshake agreements.

Now that you’re convinced to write stuff down, what do you write?

A contract is no good if it isn’t enforceable. To be enforceable, a contract must be made by people who are legally able to make a contract (generally, adults who understand what they are doing), must have a lawful purpose, and must have an offer, acceptance, and consideration.

An offer is exactly what it sounds like – a promise to do something if the other person will do something else. Acceptance means both parties agree to hold up their end of the bargain. Consideration is payment. Consideration can be money, a promise, an action.

The Texas Comptroller’s Office has a handout that describes the legal elements of a binding contract: 

http://comptroller.texas.gov/procurement/pub/contractguide/LegalElementsofaContract.pdf.

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Writing it Down: 3 Excuses, Excuses

My last post noted how writing things down supports healthy business relationships. If writing things down is so important to protecting a healthy business, why don’t people do it?

Common reasons for resisting written agreements are:

“I do deals on a handshake. It’s a matter of trust.”

“It’s too expensive; I’d have to hire an attorney.”

“My friend wouldn’t break a promise. He’d never do that to me.”

None of these are good excuses from my perspective. I’ve seen too many business relationships deteriorate as a result of otherwise savvy business owners adopting these excuses. Let’s explore the problems with handshake agreements.

  • Verbal agreements are too broad. People invariably do not remember details exactly the same way; therefore, a handshake agreement often will lack all of the necessary terms of the agreement. Example: Joanna installs tile. Bert hires Joanna to install tile in his bathroom for an agreed price payable half up front and half when the job is complete. Joanna estimates the job will take 2 days to complete. Bert selects tile from Joanna’s sample books. Joanna installs the selected tile and matching grout. Bert is unhappy because he wanted contrasting grout. The grout decision was a missing term. Bert demands that Joanna remove and replace the grout at no extra charge. Joanna believes their contract requires Bert to pay the rest of the agreed price and re-negotiate a new contract for removal and replacement of the grout. The parties have created their own mess. At a minimum, Joanna should be using a written work order or estimate that clearly lays out what work will be done, what decisions the customer will make, and how changes will be handled.
  • Verbal agreements can be ambiguous. When terms are not reduced to writing, they are subject to differing interpretations much the same way that two people witnessing the same event often describe it differently. Even lawyers are guilty. Example: Samantha cannot afford a lawyer to handle her entire divorce. She hires Amanda’s virtual law firm to provide limited scope services to aid her in handling her own divorce. Both agree that for a flat fee, Amanda will draft the divorce petition and court orders, give Samantha instructions for filing the petition, and provide a publication explaining the divorce process including how to handle the final hearing. In the interim, Samantha agrees to pay her spouse a small sum every month to cover an unexpected home repair. Samantha expects Amanda to draft an agreed temporary order since their flat fee covers “court orders.” Amanda disagrees. Her intention was that “court orders” included only the final divorce decree. “Court orders” in this context is ambiguous. A written agreement signed by Amanda and Samantha would have given Amanda the opportunity to spot the ambiguity before agreeing to provide services and, even if imperfect, writing down the parties’ expectations would have given them a starting point for discussing adding services to their agreement.
  • Oral agreements are hard to enforce, and agreements are worthless if they are not enforceable. Agreements are not enforceable if all the parties have not agreed to all the terms. Example: Ben and Dan form a partnership to start a mobile car wash service. Ben owns a panel van that he will contribute to the business. He estimates the van is worth $10,000. Dan will contribute $10,000 in cash for start-up costs. Both will work without salary for 6 months, and Dan will “manage” the business. After 60 days, the relationship starts disintegrating. It seems Ben and Dan can’t agree on anything. Ben has had enough and kicks Dan out of the business. Ben claims all of the improvements Dan made to the truck belong to him. Dan wants his $10,000 back and wants to be paid for the time he spent building the business. Since the parties never agreed to an exit strategy, Dan has no contract that provides him reimbursement for his time or his money. Dan must rely on common law theories of recovery to get his money back and soon realizes that attorneys’ fees and litigation costs will exceed his initial $10,000 investment. While he may be able to recoup attorneys’ fees after a trial, he decides a lawsuit is a risk he does not want to take.
  • Verbal agreements are susceptible to differences in memory making the proof of terms a matter of which party is more credible. Lawyers call this a “he said/she said” dilemma. Example: In the previous example, Dan visits a lawyer. He explains his agreement with Ben, and wants to know how to get his money back and get paid for his time and efforts to build the business. After a few minutes of hard questioning, Dan realizes that by not writing things down, Ben can simply deny the terms of their agreement. Whereas a written agreement speaks for itself, to enforce their verbal agreement, Dan will have to find witnesses and other evidence to prove every part of the agreement. Most of the terms were made in private conversations between Dan and Ben, so most of Dan’s witnesses are relying on Dan’s description of the agreement. Dan’s lawyer calls this hearsay and explains it may not be useful in court. A legal action to enforce their agreement will come down to who is more believable under the pressure of a court proceeding.

A trusting relationship does not cure the parties’ failure to communicate effectively. The failure to define all important terms can be fatal to any agreement. Writing things down gives people the opportunity to avoid future problems.

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Writing it Down: 2 It's All About the Relationship

Every profitable business is a complex web of relationships. Think about it. Common relationships on which a thriving business is based include:

Customer-Supplier

Co-Owners (shareholders, partners, members)

Employer-Employee

Supervisor-Supervisee

Owner-Management

Business-Regulators (taxing authorities, licensing boards)

Landlord-Tenant

Networking partners

Of course, there are more. On the most basic level, a business cannot exist without customers, and a business will not last long without strong customer relationships. Every profitable business is built on a web of thriving relationships. Relationships are strong when everyone is on the same page, expectations are clear and realistic, and the parties trust each other to do what each has agreed to do.

 

Relationships deteriorate when everyone is not on the same page, expectations are ambiguous or unrealistic, or someone fails to keep a promise. Many times, misunderstandings between parties cause or contribute to the deterioration of otherwise healthy relationships. Misunderstandings happen for a number of reasons – many of which are avoidable. A common cause of misunderstanding is the failure to accurately describe a task to be performed. Who will do what by when, and how will it be done?

Details may be assumed differently by various parties when the details are not written down. For example, John hires Dan to paint a wall. The two negotiate a price and a time for completion. Dan paints the wall. John refuses to pay full price because Dan did not prime the wall before painting it. A critical item was not discussed. Dan assumed the wall did not need priming because it was not discussed. John assumed that any painter would prime the wall first. Now, everyone is dissatisfied.

Had the two written down the terms of their agreement, they may have uncovered the missing information in time to clarify and correct. This example uses a very simple agreement. In reality, the more complicated an agreement is, the more terms and details are needed, and the more steps toward completion of each party’s agreed tasks, the more critical it is to write everything down.

Dan and John did not need a lawyer or fancy language to write their agreement. Their agreement could have been in the form of a work order signed by both of them. It seems obvious that a written agreement would have helped them avoid conflict and would have led to a better working relationship. So, why do we resist writing things down? My next post will explore our propensity to rely on a handshake over pen and paper.

Writing It Down: Series 1 Enforcing An Oral Contract

Lately, I’ve been a single question several times.

How do you enforce an oral contract?

Answer: It’s difficult but often not impossible.

The question actually raises questions: how are you going to prove you have an oral contract? Will the breaching party admit the to making the contract? Not likely. Do you have notes, emails, texts, anything in writing? Are there witnesses to the conversation? If so, are they reliable? If not, have the parties started performing?

And the questions go on and on trying to build a trail of reliable, admissible evidence to prove up the oral agreement. One must also ask, is attempting to enforce the verbal agreement in court going to be cost effective?

Of course, that depends on the agreement. It likely is not cost effective to file a lawsuit over a low value agreement, but may well be worth the time, money, and effort to enforce a high value contract. There are avenues to try before filing a lawsuit.

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Sometimes, a written demand for performance does the trick. Mediation is also a less costly alternative to a lawsuit if the other side is willing to participate. Most people who ask me the question realize it would have been easier to have reduced the agreement to writing.

Thus, this series was born. I’m calling it “Writing It Down.” This series of posts will explore using simple written agreements to support small businesses.