Level Up: Legal Business Agreements
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Question from Lindsey, Albany, NY:
I’m working with a friend on a business idea and we need to create an agreement on how to work together. Do you have suggestions for what we should do?
Answer from Marissa Wiley, Nixon Peabody:
You are certainly on the right track, considering that you recognize the need for an agreement. It is key to come up with a specific and carefully articulated agreement that outlines your collective goals and respective responsibilities, compensation, and authority.
Business enterprises between two people, whether it be two friends, family members, or former coworkers, are sensitive and fragile organisms. When both parties agree, you can work together to promote a common goal in a way that one person alone could not, by amplifying each other’s strengths and making up for individual weaknesses. However, in the event that the two do not see eye to eye, a joint venture can come to a grinding halt, which can be devastating to the business and the individuals. Or, if one person is empowered to call all the shots, the disempowered person may find themselves locked into an arrangement they no longer support.
With that risk in mind, my first piece of advice to someone who is beginning a two-person business where both parties have equal control is to consider finding another, independent third person to add to the mix. The third person can serve as the tie-breaking vote to help ensure that the business continues to run smoothly, despite differences in opinion among the group.
My second piece of advice to anyone beginning a business of any kind is to form a separate business entity, such as a limited liability company or a corporation. The kind of business structure that you should form is a fact-driven determination, and you should discuss your options with an attorney and an accountant. A separate business entity will limit the individuals’ liability for the company’s debt and formalize the arrangement among the owners—here, the folks starting the business. In addition, a business entity will be necessary in the future when the venture takes off. Investors, future partners, and acquirers will expect the business to exist in an official form. It is best practice to locate the business, so to speak, in an official entity as early as possible in the business’s lifetime. While the cost of forming such an enterprise varies, it can be quite economical and very much worth the small expense.
When you form a business entity, the governing documents of the entity can and should serve the purpose of setting out the explicit understanding between the parties. For example, in a limited liability company, that understanding will be articulated in the limited liability company agreement, sometimes known as the operating agreement. Entering into this agreement will be a useful exercise because it will force you to consider a variety of issues and potentialities and to focus on aspects of owning a business that you may not be thinking about, given your appropriate attention to getting your new enterprise off of the ground. Some of those questions include:
What is the purpose of the company?
Who will have decision-making power?
How will the business be funded?
How will the business pay its owners?
What is the exit strategy?
How do the owners transfer their ownership in the business or otherwise leave the enterprise?
How do the owners dissolve (i.e., completely terminate) the business?
Should owners be allowed to compete with the business?
Do the owners have confidentiality obligations?
What are the owners’ indemnification rights?
It is particularly critical in the two-owner scenario to include a clear and deliberate articulation of power between the two of you and a way to exit the business in the event things are not working out. For example, a party or both parties could have the right to force a buy-out or liquidation of the business. With protections like that in place, if interactions break down, you will have enough agency to, at least, terminate the business, monetize your investment, and move forward on your own.
With all of that said, my final and most critical piece of advice is to talk to a lawyer about your business plans. There are significant consequences to these decisions, which affect your ability to make a return on your investment, to protect your own interests, and to avoid tax pitfalls (to name a few), and it is well worth the investment to receive the counsel of an experienced professional.
Good luck with the new venture!
This blog post is intended as an information source for members and friends of Upstate Capital Association of New York. The content should not be construed as legal advice, and readers should not act upon information in this publication without professional counsel. This material may be considered legal advertising under certain rules of professional conduct.
Marissa Wiley
Marissa B. Wiley is a partner in the Corporate & Finance group for New York-based law firm, Nixon Peabody. Marissa focuses her practice on mergers and acquisitions, private equity transactions and general corporate work.