Organizational Documents are Imperative to an Entrepreneur’s Business

Organizational Documents are Imperative to an Entrepreneur’s Business

An entrepreneur has an idea…a vision…a way to make money…a niche to fill. She has the know-how, she has the connections, she has the backers and maybe partners. Now, she needs an LLC.

The entrepreneur should be aware of numerous complications in setting up his or her new entity.
First, entities come in a number of different flavors: C corporations to S Corporations to the LLC (limited liability company) to the LLP (limited liability partnership). All of these entities provide a form of liability protection if they are properly formed and administered. But, they are each unique in terms of tax ramifications, organization structure, voting rights, and management rights. Oftentimes, the word “LLC” is used as a generic term for any entity. And, it is true that often the LLC is the entity of choice as it offers superior flexibility. But, the entrepreneur should discuss the best entity options with his or her accountant and lawyer. Indeed there are probably more than a dozen considerations when choosing the entity for your new business. Most of the considerations are tax related. For example, appreciating property should generally be put into an entity subject to passthrough tax or disregarded entity status (the LLC or the LLP), while an operating business may seek to save on the payroll tax of 15.3% by paying the owner a low wage coupled with higher distributions (S-corporation). A company that is seeking to hit a home run and eventually go public has (practically speaking) one choice (C-corporation).

For each type of entity, there are the associated organizational documents. Though each entity has its own vocabulary, the documents are substantially similar. Where a corporation has Articles of Incorporation and Bylaws, the LLC has a Certificate of Formation and an Operating Agreement. Where the corporation has “stock,” the LLC has “units.”

For an entity that is to be owned by just one person (or a married couple), the planning considerations are much simpler. Proper planning for the sole-owner entity is important, but by and large, the organizational documents are not. A sole-owner entity is not bound by the organizational documents. The owner can change the relevant provisions of any controlling documents at any time (as they should be able to do as the sole owner). So, the planning is drastically reduced.

But add one more owner and the organizational documents become of utmost importance. The organizational documents define the rights and obligations of the parties to each other and to the entity. Once formed and operating, there may never be an opportunity to plan for the business again. So, at the outset – at the time of organizing the entity – that is the time to spend the time planning for the multi-owner entity. Choosing the entity is simply the first task.

The owners of a multi-owner entity must decide on a whole host of planning considerations. Broadly, these considerations include the so-called “Buy-Sell” issues and the “Non Buy-Sell” issues. First, the Buy-Sell issues. The parties usually go into business together expecting some kind of relationship. Let’s take Jim and Ken. Jim and Ken get along and want to go into business together. The Buy-Sell issues that need to be addressed include things like: (1) Can Jim sell his shares to his friend Tom or gift the shares to his favorite charity or pass the shares to his wife upon death? All of these issues change the partnership that was originally envisioned by Jim and Ken and forces Ken to take on a partner he didn’t originally envision. (2) Upon what event may or must the shareholders or company buy out the other shareholders? Disability? Death? Bankruptcy? (3) How do Ken and Jim value the business for these purposes?

The Non Buy-Sell issues revolve around the ongoing administration of the entity. Issues that might be addressed include things like: (1) What are the plans for cash distributions from the entities to the owners? (2) What are the business plans for the entity and might those plans affect cash flow to the owners? (3) May an owner compete with the entity? (4) Must an owner work for the company (remember, ownership is separate from employment unless you make it otherwise)? (5) What kind of tax elections will the owners make (some elections require unanimous consent)?; (6) Are owners bound by confidentiality covenants?; and a whole host more.

Often, as owners walk through the planning process with a planning attorney, the discussion identifies a host of issues they had not yet discussed. And, this leads to a more robust understanding of each party’s intentions for the business. That kind of understanding also translates into less uncertainty and less conflict in the future.

It’s not that a handshake is insufficient for trust, it is simply that the handshake does not define and communicate all the rights and obligations that each party is expecting. Sometimes, this planning process uncovers disagreement and ultimately the deal falls through. But, better to disagree and allow the deal to fall through early rather than attempt to unwind a deal years down the line after significant energy and resources have been expended on the business. Thorough planning early clarifies expectations and sets the foundation for an entrepreneur’s future success.

Organizational documents are imperative for entrepreneurs starting a business. This article digs a little deeper into a specific issue that comes up in the organizational documents: the buy-out of a deceased owner’s share of the company.

Let’s use Linda and Jane for our example. Both Linda and Jane are married. Linda is married to Tom and Jane is married to Phil. Linda and Jane decide to go into business together to run a widget factory (“Widgets Inc.”). Linda and Jane have had a long relationship, but neither Linda nor Jane cares for the other’s spouse. So, if anything ever happened to Linda, Jane would not want to be in business with Tom. Plus, the company requires both Linda and Jane to work (active versus passive ownership) for the company to be successful.

First, the organization agreements are going to cover this situation. There will be a buy-sell agreement written into the documents that restrict transferability, even to a spouse. Further, the organizational documents will recognize that neither owner wants to be an owner with a spouse upon death. The buy-sell then includes mandatory buy out provisions. So, if Linda dies, then there is a mechanism to ensure that Jane still owns the company but also that Tom receives the value of his wife’s interest in Widgets Inc. And, because this is a community property state, the spouses (Tom and Phil) will agree to these provisions in writing.

Now, the unexpected occurs and Linda dies.

The problem is that cash flow at Widgets Inc. is tight. And Linda’s death was unanticipated. Fortunately, the parties can lean on their well-drafted buy-sell agreement to alleviate the problems and stress accompanying this transition period. It says that upon a death, Widget Inc. agrees to buy out the deceased shareholder’s interest at a specified value (or a specified valuation methodology) through the use of a promissory note over a term of say 10 years. This allows Widgets Inc. to create the cash flow to buy out Linda’s interest and provide cash to Tom.

But, life insurance provides a better solution. The company can carry life insurance on the owners. It can be structured as a term or whole life policy. Let’s assume we utilize term insurance. Term insurance is inexpensive to maintain and can guard against the risk of an untimely death. Often, insurance is used to cover the mandatory buy-out. So, instead of an installment note, Tom receives the full value of Linda’s interest in the company (funded by the insurance) in exchange for giving up the shares of stock in Widgets Inc. owned by Linda. Keep in mind, the insurance should pay to Widgets, Inc. rather than Tom so that Tom cannot later assert Widgets, Inc. still owes him the value of the shares. This is a common mistake among businesses with whom I have worked.

The insurance can be structured as owned by the company with the corresponding obligation of the Company to buy or redeem the stock of the deceased shareholder. Or it can be owned by the owners individually in a “cross-purchase” arrangement with the corresponding obligation of the shareholder to buy the stock of the deceased shareholder.

The question of whether to structure the insurance as company-owned or cross-purchase involves several key considerations. First, the number of owners determines the complexity of the cross-purchase arrangement – the more owners, the more complicated. Second, in the company-owned arrangement, the owners will not get the step-up in tax basis as they would with the cross-purchase agreement and the company might be subjecting itself to the Alternative Minimum Tax (AMT). The third consideration is the percentage ownership of the entity. It may be become unfair for a cross-purchase agreement where one owner owns substantially more than the other, as the buyer will necessarily need to pay more to hold the insurance on the majority owner.

Insurance needn’t be used only to fund the buyout upon death. It can also be used to fund a buy-out upon disability. In the event Linda becomes disabled, and where her continued work was vital to the success of the organization, it might make sense to trigger a buy-out upon disability.

With any buy-out provision, care must be taken to provide a reasonable value for the company or a reasonable valuation methodology. In the event the insurance proceeds are insufficient, the difference can be paid through the installment note. If the insurance is greater than necessary, the company (or the other shareholder) can keep the difference to make up for the likely income loss from the deceased shareholder. No matter how the agreement is funded or structured, business owners, their insurance agent, and their attorney all need to work closely together to ensure the plan works.

Through the use of a well-planned, insurance-funded buy-out, all parties win.