Owner Agreements: ByLaws and Operating Agreements

Next article in my “business startup series” of articles. Today I’m discussing what owner agreements should be in place for a business with multiple owners. Owner agreements should define who makes what decisions about how the business is run and the money spent, how profits are allocated, and how the business is split up on liquidation.

When setting up a business, this is really the area where owners should put a lot of thought and spend some money (on my services of course) to get their agreements down on paper, correctly, before there is a dispute. Once everyone is arguing about these topics, I have news for you: those “form” agreements you downloaded from the internet and never read are not going to help you.

Why We Have Owner Agreements

The state statute requires that owner agreements be in place in a business. That’s the simple, easy answer. That said, the statute does not in any manner dictate the contents of those owner agreements. They can be one sentence long, “I run this business” to, I’ve seen, over 150 pages long. It just depends on what the owners want stated in them.

As the name implies, these are agreements – contracts, that is – among the owners of a business as to how the business will be run. I get deeper into this concept in my seminars (by the way, contact me if you want me to speak to your business group about this or any topic), but briefly these owner agreements allocate levels of control and decision making in the business. Shareholders, Board of Directors, and Officers for a corporation; and Members and Managers for a limited liability company. Each of these entities/people have some, but not all, decision making authority in a business.

It all just depends on how the original owners of the business set it up. That’s why I call them “owner agreements”.

business owner agreements
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What Goes In Owner Agreements

There are, again, generally speaking, three things that I put into all the owner agreements I draft for my clients. These are: who makes what decisions; how are profits allocated; and how will the company be liquidated or sold. Most things you’ll see in these agreements can fit into one of these three categories. A fourth category, which I leave out of my “generic” documents, often requires extra drafting (and fees) and can include succession, buyout, or how do new owners come into the business (buy-ins).

Control of Decisions

With two or more owners, the agreement needs to have a mechanism to allocate decision making. Most often it is based on either who owns the most equity / shares; or the parties can pre-designate who (or which group) makes certain decisions. An example might be the decision whether to sell the company in a buyout. Shareholders are the group that would profit from this event, but there may be shareholders who either want to continue reaping ownership profits, or who think a better deal may be had.

On the other hand, the Board of Directors is the technical group that “runs” a company. And depending on the ability to muster shareholders for a vote, it may be more efficient to let the BOD make the decision whether to sell the company. So as you can see, shareholders and the board of directors both have an interest in the outcome of this decision. Good owner agreements will allocate which interested group makes a decision like this.

Similarly, the decision whether to buy a new, multi-million dollar piece of equipment could be allocated to the company’s officers, who are charged with the day-to-day running of the business and implementing the plan set out by the BOD; or to the BOD which has the oversight authority for the business and, if drafted properly, spending authority for the business over a certain amount.

Allocation of Profits in Owner Agreements

For a corporation this is generally simple: the owner of one share gets to share in the profits equal to that share divided by the number of outstanding shares. In a limited liability company, however, “ownership” of the right to receive profits does not have to reflect the number of owners or the allocation of decision making. It can get complicated, but it’s a lot more flexible to balance the three factors I’m discussing here.

Sale and Liquidation of the Business

I put this in a separate category because technically it is a separate right of ownership. So there’s the right to participate in management of the business; the right to participate in profits; and the right to receive proceeds from liquidation of the business.

It’s important, in my opinion, to deal with this right separately, because different owners may have contributed different amounts to the company; or materials; or labor. So, an owner whose capital contribution to an LLC was a piece of heavy equipment worth $500k might want that returned if the company is shut down. Another owner, who contributed $100k in cash, might want that returned (if there are sufficient assets). Let’s get that down on paper when the company is formed.

Conclusion on Owner Agreements

If you have any questions on this go ahead and contact me. Stay tuned for more parts to this series on the new business startup cycle.

In western North Carolina, Asheville, Waynesville, Hendersonville at (312) 671-6453 or palermo@palermolaw.com.

Be sure to check out my other blog posts HERE.  Be sure to listen to my podcasts with Matt Mittan at BizRadio.US