Can a Court Rewrite Your LLC Agreement? You Might Be Surprised.

What do you do if you never put a limited liability company operating agreement on paper?  In some cases, the answer may be decided against your wishes by a court. I was recently speaking with a small business owner who ran into trouble with the other member of his limited liability company.  The two had formed the LLC six years ago by filing with the Commonwealth but never put an operating agreement on paper.  However, he indicated that they had an oral agreement on a variety of things that would normally be in an operating agreement - how the LLC is managed, how the profits and losses are divided, how to buyout a member who leaves, etc.  Now he wanted to use some of those agreements to resolve the conflict.

In Massachusetts (as well as many other states), a written operating agreement is not required; members can have an oral agreement on how their company is structured and operated.  But that flexibility can bring risk.  Here's why.

States have a common law concept called the "statute of frauds".  (For those of you who eyes are immediately starting to glaze over at the sight of technical legal talk, you can skip to the paragraph that begins "So what does this mean for your company?" to understand the practical implications.) State laws vary, but generally the statute of frauds states that certain contracts must be in writing and signed if you are going to enforce them.  In addition to other things, this common law principal includes any contract that cannot by its terms be performed within a year.  Note that an agreement that happens to take more than a year is not automatically subject unless the agreement specifically states that it will take more than a year.  If so, the contract is not automatically void, but one party can raise the statute of frauds in order to have the contract voided.  Remember that this is a complex topic because there are some exceptions, but as a general principal, long-term unwritten agreements carry some uncertainty.

This issue became much more relevant to LLCs last year when the Delaware Chancery Court ruled that an oral LLC agreement was subject to the statute of frauds.  In Olson v. Halvorsen, C.A. No. 1884-VCL (Del. Ch. Dec. 22, 2008), a hedge fund founder who was removed by the other members demanded that the court enforce a multi-year earnout agreement that was included in their unsigned draft of an LLC agreement - an earnout worth well over $100 million!  The court held that because the earnout was to be paid over the course of six years, it falls within the statute of frauds and was therefore unenforceable.  The former hedge fund manager's claim for the payout was rejected.

The applicability of this case in Delaware adds some uncertainty to the operating agreements of LLCs formed there.  Other states, including Massachusetts, have yet to decide this issue definitively, but the Delaware courts often serve as a model for other courts when they are facing corporate and LLC issues.  So this decision may eventually have implications for your agreement.

So what does this mean for your company? If your LLC is operating under an oral operating agreement, many of the provisions with respect to management and such may be enforceable because they can be performed within a year.  However, as the court decided in Delaware, if you have an oral agreement with the other members that entitles you to some benefit that extends beyond one year, you may lose that right in a dispute.  For example, if the members agree that if you were to be hit by a bus tomorrow, the other members would buy back your membership interest with installment payments over five years, the other members might be able to successfully void that provision upon your untimely demise under the statute of frauds.

So here are some tips with respect to operating agreements in light of this case law:

1. Put your LLC operating agreement in writing.  Operating Agreements do not have to be fancy.  You can write the provisions of your agreement in any way that expresses the true intent of the parties.  Working with a lawyer may help save a tremendous amount of agony since they have experience in drafting agreements that will be enforceable.  But don't get caught up in the formalities - just get it in writing.
2. Make sure everyone signs the agreement.  A critical element of the statute of frauds is that the agreement must be signed by the person against whom it will be enforced.  As in the Olson case described above, the members wrote out the provisions of an agreement, but the courts did not enforce it because the parties never signed it.  I have dealt with other situations where clients "forget" to sign a document.  It may be easily overlooked a the end of a negotiation, a critical issue to protecting your rights.
3. Revisit your agreement periodically.  Companies that have been operating for several years might be surprised by what is in their operating agreements because the needs of the members and the company may change over time.  This is even more important if you are operating with an oral agreement.  After a few years, the members may have very different recollections of your agreement, which may lead to messy disputes down the road.  I would recommend that you take a fresh look at your agreement annually when you have an annual meeting.

New Model Startup Docs Give Entrepreneurs a Head Start - Do You Still Need a Lawyer?

Startup companies just got new tools to make the formation process a little easier.  With the help of the law firm Wilson Sonsini Goodrich and Rosati (if you are a California startup, you have undoubtedly heard of them), TheFunded.com offered up this week its contribution to the recent and growing trend of publishing early stage documents for startups and emerging companies with publication of the following form documents:

• Bylaws
• Certificate of Incorporation
• Initial Stockholder Consent
• Invention Assignment Agreement
• Restricted Stock Purchase Agreement
• Indemnification Agreement
• Initial Board Consent
• Action by Incorporator
• Plain Preferred Term Sheet

These are the basic documents used by startup companies to get their ventures off the ground.  The Certificate of Incorporation is the only document that is filed publicly with the state, the others govern internal matters within the company.

This is not the first set of legal documents to be released, but most of the other forms have been in the early stage equity investment area.  Wilson Sonsini itself published a term sheet generator for each stage venture investment deals, TechStars published a set of model early stage investment documents earlier this year, and of course, there are also the National Venture Capital Association forms for early stage venture investments that have been out for several years.  In fact, other firms and organizations have released form documents in an effort to make the process of formation early stage financing easier, cheaper, and more efficient.  Wait, did someone accuse lawyers of being inefficient?

So startup lawyers are now expendable?

Don't jump to conclusions too soon.  These documents can give you a sense of what is involved in formation and also provide a baseline for your final agreements.  However, there are still many things here that you should discuss with your attorney.  There is no such thing as a one-size-fits-all set of formation documents.  Each company will have individual needs based on the structure of the organization, the people involved, etc.  For example, you should at least consider the following:

1. These documents assume that your startup is incorporating in Delaware and is located in California.  State laws of formation differ and your state may have different requirements that will have an impact on the documents.
2. These documents are founder-friendly in that they give a lot of control to the entrepreneurs who form the company.  That is great for the entrepreneurs but may become problematic if you have other investors or third parties involved who want to share in that control.
3. You may need to consider an additional agreement for the founders to cover other contingencies that affect their relationship.  Remember that everyone is happy to be in business together at the beginning.  But a little planning up front will help to resolve disputes later.
4. If you sign a restricted stock agreement, you will likely (in almost all circumstance) file an 83(b) election.  This must be filed at the time you sign or within 30 days in order to enjoy the benefit of recognizing tax on the value of the shares of the fair market value (which should be $0.00 at the time of grant because they are given at fair market value).  The alternative is that you will be taxed at each stage of vesting - if the company increases in value, you could be stuck with a tax bill each time without any liquidity (i.e. no cash is paid to you at vesting from the stock).

The bottom line is that forms like these give some more power to entrepreneurs in taking control over the formation process.  And because they come from reputable organizations, you can have a piece of mind that you might not find with other online sources.  But with this new control comes the responsibility to make sure that you understand what you are getting into.   A good startup attorney can walk you through the pros and cons of these documents so that you can feel confident that you are setting up a strong organization.

The Other Thing You Learned at College For Your Small Business

Remember sitting in class in college listening to a professor fill you head with knowledge that would eventually form the basis of your business?  Well now the time you spent in the dorm might help as well.  Small and startup business are increasingly sharing office space.  This system of "co-working" - sort of like finding a roommate for your business - is catching on in this economy because it offers more flexibility and lower costs to startup businesses.  According to the Wall Street Journal:

[S]mall business owners and professionals share space and office equipment, and pay short term leases, usually month to month. ... For entrepreneurs, it's a cheaper and more flexible alternative to renting or buying space of their own.... [Tobias] Roedinger estimates he is saving $300 to $400 per month on utility bills and not having to rent space he doesn't need.

Even more interesting is the fact that these co-working spaces are sometimes employing bartering rather than rent. According to Winnie Fung, a manager of a nonprofit co-working space in Brooklyn, N.Y.:

At least three or four people from the 10 in her co-working space have partially or fully bartered their services for desk space. ... Ms. Fung says a few months ago she made a deal with one of her members, a tech start-up owner, to look after the building's computers and Internet service in return for free space.

As I have written about before, start-ups will do themselves a service by bootstrapping as long as possible when getting started in order to maintain control and options for later.  This type of cost-reducing move can not only improve your bottom line, but also provide added networking.

Where should you incorporate your business?

I was involved in a discussion today with an entrepreneur who was planning to incorporate his business but was wondering where to do it. He is located in California and was asking whether he should stay there or incorporate somewhere like Delaware or Nevada. I have written before about the whether or not you want to incorporate, but the location of your incorporation is another discussion you should have with your attorney. You can choose to incorporate your business in any state, though you will typically want to file in your home state (the state where your operations are located) unless you have a compelling reason to choose elsewhere. Filing in a different state does not excuse you from the filing requirements and corporate taxes of your home state. If you are located in California, you are going to have to pay California taxes and fees either as a domestic California corporation or as a "foreign corporation", which is a corporation filed in another state.  In addition, you will likely have to pay for a registered agent in the state you choose if you do not have an office there.  So choosing another state because it has lower fees doesn't necessarily work.

There are many companies that choose to incorporate in Delaware even though almost none of them are actually based there. In fact, approximately 60% of the Forture 500 companies are incorporated in Delaware. There are two main reasons for this: (1) the Delaware corporate laws are generally favorable to management, and (2) Delaware has created a special Court of Chancery whose jurisdiction is to hear nothing but business law cases. See, in other states, your business case could be heard by the same judge who just heard a criminal matter, or a domestic dispute, or an environmental action. The Delaware Court of Chancery's focus on corporate law provides a certain amount of predictability and consistency that you may or may not find in other states.  However, many large and small companies will choose for a variety of reasons to incorporate in their home state (for example, even large tech companies such as Apple Inc. and Microsoft Corporation are incorporated in California and Washington respectively).

Nevada is also mentioned on occasion, primarily because it has liberal rules with respect to privacy, very pro-business laws, and a beneficial tax policy (read: no corporate, franchise, or income taxes). It has also developed a court similar to Delaware's, but because it has not been around nearly as much, it has much less established case law.  New York is a state that is often used as the governing state law in commercial transactions, but getting through the incorporation process there can be onerous.  And some states have laws that you might prefer to do without.  California, for example, has a very strict policy of not enforcing non-competition agreements other than in connection with the sale of a business.

Again, you should consult with an attorney who can help you sort through these issues.  I often have this discussion wtih new clients as part of a free initial consultation, so the cost should not get in your way.   But you need to have this conversation to prevent making mistakes that will cost you much more in the long run.  The bottom line is that unless you find factors that outweigh any deficiencies of your own state's laws, you will generally be better served in your home state.

Getting your business plan off on the right foot.

If you are thinking about dragging yourself out of the recession and launching that new venture, you should read this great article from the Wall Street Journal today to make sure you get it started right.  Often, new ventures fail before they even get started from a lack of planning.  But as John W. Mullins notes, there are some basic ways to ensure your business plan ends up on investor's desk rather than the recycling bin.