Every business needs a legal and business structure, both for day-to-day operations as well as a business exit strategy. A corporation and a limited liability company are the most common legal structures used by entrepreneurs and new business owners. Both require well-drafted agreements, called the LLC Operating Agreement or a Corporate Shareholders’ Agreement.
A business exit strategy is often associated with building the company with a future sale in mind. However, there are other reasons for a business structure, one that contemplates not only business operations and insulation from liability, but also provide for sudden departures of shareholders or members due to death, illness, or withdrawal.
When building a team-managed business, your business structure and exit strategy are all the more important to properly implement. There are differing, but equally important considerations for both the family-owned business, as well as the partner/investor business. First, I’ll share the key points to remember to button up the legal structure for the partner/investor business.
In Part 2, we’ll review a checklist of essentials for the family-owned business operating as an LLC or corporation, and the estate planning tips for both types of businesses.
Do you know the benefits of the business structure?
Avoiding Personal Liability & Risk to Personal Assets
No one wants a creditor or business failure to put your home or basic life necessities at risk when launching a new business. If your business is sued, and absent a personal guarantee on a loan or note, your personal assets are not at risk to enforce a judgment. Yet, there are other equally important reasons which require consideration.
Continuity of Life
No one likes to contemplate the inevitable. Death, serious illness, or acts of God. Unlike humans, an LLC or corporation continues on in spite of any of these events. Yet, it’s a misleading statement to assume this is true if the requisite details are overlooked. An exit strategy in case of one of these unexpected events is as important as a plan for a future sale.
As an attorney who has litigated many cases, I’ve represented clients that ended up in difficult situations, often because of some part of the business structure that was left incomplete or overlooked. The statement “The devil is in the details” certainly applies to setting up your business structure.
The details make a difference between a business that is future-proof, and one thrown into unexpected crisis as a result of failure button up the details of a business structure. The time and expense of properly housing your business operations and assets pale in comparison to the cost and disruption that comes with unfinished business.
Five Tips to Future-Proof your Business Structure
The Corporate Shareholders Agreement or LLC Operating Agreement
A limited liability company requires a well-crafted LLC operating agreement. The corporate structure has a similar agreement called the shareholders’ agreement. Both types of agreements are essential not just for management of the company and voting rights of control, but for death and disability. I once litigated a case where a corporation with 5 members operated with no corporate shareholders’ agreement for 25 years, and it landed in court when the founding member and owner was locked out of his own company!
A shareholders’ agreement and LLC Operating Agreement should always include the following key provisions:
Death or Disability
Without an agreement requiring a buy-out of shares by the company of a deceased partner or shareholder, the company can find itself in business with the spouse or children of the deceased or incapacitated member or shareholder, or a non-participating spouse in managerial control of the business.
Withdrawal or Expulsion of a Shareholder
Absent a provision in the agreement restricting transfer to third parties, a withdrawing shareholder or LLC member is free to sell his or her shares or membership interests to a stranger. A restriction on transfer requires that leaving member shares be sold back to the company, or offered to the remaining shareholders is essential.
Business Valuation Methods
Poorly drafted agreements often lack valuation methods and reference payment of “book value” for the shares or membership interests. Book value is a highly discounted value after deducting nearly expenses. This may be an advantage for the company, but for the exiting shareholder or their estate, it’s an unfair and often inaccurate assessment of the value of the company. An agreed method for obtaining a fair and independent valuation should be included. There are 5 common methods of business valuation. Learn more in our interview with valuation expert Melisa Silverman.
Payment of Purchase Price
Any agreement should specify payment of the price for shares be made in installments in order for the company to orderly fund what could be a large payout. The company should consider key person life insurance to fund buyouts of key owners to prevent financial impact upon business operations and ensure uninterrupted business operations.
Ownership or Licensing of Intellectual Property
The most valuable business assets are often intangible, including trademarks, copyrights, trade secrets, and know-how. The LLC or corporate structure is a terrific vehicle for owning these valuable business assets and allows for creative licensing arrangements among company divisions or investor vehicles. There are exceptions to holding title in the name of the entity, particularly when the company brand is a personal brand. In the case of a personal brand, a revocable license to the company by the individual is a more prudent alternative. A few years ago, a famous vintner in Paso Robles lost control of the winery he founded, after bringing in outside investors. Not only did he lose control of the winery, but he also lost his name, since it was an asset of the corporation.
In short, don’t overlook the details when it comes to your business structure. A good business exit strategy includes more than the future sale of your business. Don’t overlook the inevitable unexpected life contingencies.
In Part 2, we’ll review a checklist of essentials for the family-owned business operating as an LLC or corporation, and the estate planning tips for both types of businesses.
Need help in securing your own business structure and exit strategy, contact us.
