Posted On May 04, 2016
About two-thirds of all new businesses in the U.S. start out as LLCs, or limited liability corporations. Entrepreneurs recognize that LLCs combine the protections of a traditional corporation with the operating flexibility that small businesses need.
We’re big fans of LLCs, but they are not without potential pitfalls. When there are problems, it’s usually because the LLC members were in a hurry at the outset, and didn’t take advantage of all the safeguards and flexibility this business formation entity allows.
Do it your way with an operating agreement
One of the most frequent issues we see are family or friends who form LLCs without an operating agreement. Entrepreneurs anxious to get their businesses off the ground may think, “We have a great idea and we’re all family or friends – why do we need an operating agreement?”
We could go through a hundred “what ifs?” How will the LLC value the interest of a member who dies? What if one member is not able or is unwilling to make capital contributions? How will distributions be handled? How would a voluntary dissolution be handled? How will the business treat a member whose creditors foreclose on his ownership interest? What is each member’s role in management – if any? Can a member sell or transfer an interest to a family member without the permission of other LLC members?
There are good answers and a range of options for all of these questions, and tens of thousands of previously formed LLCs have provided a roadmap for what works. If you don’t address these questions in an operating agreement, however, you could end up hammering out the answers in court or have to fall back on the state’s default rules, which may not be to your liking.
Take the extra time to talk through these issues with a lawyer experienced in business formation and get it right on the front end with an operating agreement.
Informal business protocol works well — until it doesn’t
One of the attractive aspects of an LLC is that it doesn’t have all the formalities of a corporation, including extensive reporting requirements to state agencies, keeping minutes of member meetings (or even the requirement to have meetings), distribution of financial statements and governance bylaws. You and your partners see each other every day; why do you need a regularly scheduled members meeting or a formal financial report? And besides, you’re already working until 9 p.m. every night and the last thing you need is a layer of formal requirements that do nothing to push product out the door.
But money is a great divider, and just as the best marriages can hit stress points, so can businesses when things don’t go as expected. People say, those things aren’t going to happen because we’re all good friends. In our experience, LLCs involved in litigation commonly started out as easy relationships with friends or relatives.
It’s about the money
Somewhere down the line there will be a disagreement about distributions if you haven’t provided in advance how they will be addressed. Maybe one member is financially strapped and needs to take a distribution when other members want to plow everything back into the business. Passive investors may have different goals than those involved in running the business. Retirement and estate planning will affect what is in an older member’s best interest, and a member who has invested thousands of hours of sweat equity may feel he deserves a bigger share.
In the beginning when there is no profit to divide, this won’t be an issue, but success will make it a problem eventually. Plan ahead with a well-thought-out process for distributions and contingencies, and you can just go with the plan.
Making “the talk” easier
All of these “what if” scenarios can be uncomfortable for a business composed of family or friends. It’s a lot easier for a lawyer to introduce these questions, as well as to explain your options. There is no LLC issue we haven’t seen. Let us help you have “the talk” on the front end so that you’ll avoid more awkward conversations years later.
Mark B. Goddard is a shareholder at Turner Padget, where he has an active litigation practice specializing in business and corporate litigation, complex insurance defense matters and probate litigation. He has extensive trial and arbitration experience and has taken over 25 cases to verdict in venues throughout South Carolina. He may be reached at (803) 227-4334 or by email at firstname.lastname@example.org.