People make mistakes entering a business relationship. It is inevitable—we cannot predict the future. The best we can do is reflect on our own mistakes or those made by others and attempt not to repeat them. Here’s a list of five common mistakes we see people make when negotiating a company agreement.
The Top Five Mistakes
- Failing to prepare for future capital needs of the business.
- Failing to budget.
- Creating deadlocks (or failing to plan on how to resolve them).
- Failing to address competition by members or managers.
- Failing to prepare for a business divorce.
Mistake 1: Failing to prepare for future capital needs of the business.
A company agreement provides for “initial capital contributions” by the members of the LLC. This may be a nominal amount if the business is just getting off the ground, or a larger amount for a well-established business. The company agreement also addresses “additional capital contributions.” These additional contributions are either mandatory or voluntary.
Businesses often need additional capital to continue operations. This capital is often obtained through loans from members or additional capital contributions. Members are sometimes surprised when the company issues a capital call. While capital calls are handled in a variety of ways, if a member fails to make a call, penalties or a dilution of membership interest may occur.
How do you handle this? It depends on your position. Are you the member that is funding the operation? Or are you the person that took on business partners to obtain additional capital? In either situation, always plan to put more money in that you initially anticipate. If you do not have adequate funds to make continual capital calls, think about setting up some type of earned profits interest that allows you to initially avoid taking on a larger membership interest (and corresponding financial obligations). There are trade-offs in every situation, so be sure to discuss the risks with an attorney.
Mistake 2: Failing to budget.
This goes hand-in-hand with mistake #1. Talk about the expected budget with your potential business partners before you sign the company agreement and operations begin. Have an idea of the capital needs of the business and plan accordingly.
Consider agreeing to a budget before operations begin. Better yet, set parameters for future budgets. Consider agreeing at the outset to deadlines for producing and approving annual budgets and rules for amending budgets. These rules may allow for some percentage deviation in the budget, but once the percentage threshold is reached, require a special vote to approve the budget.
Mistake 3: Creating deadlocks (or failing to address resolution).
A deadlock occurs when a vote will not resolve an issue. For example, a majority of the members must approve an action, but there are only two members. Or the company may have two managers who cannot agree on a decision. Avoid these types of situations if possible.
However, despite the risks, parties sometimes want a 50/50 split of members or managers. The two members in our example want an equal role and an equal vote in the business. It’s understandable, but the members should discuss deadlock resolutions prior to signing the company agreement. Consider a deadlock mediation or arbitration provision.
Mistake 4: Failing to address competition by members or managers.
A member or manager of a company may be presented with an opportunity that competes with the business of the company. For example, a company may operate a restaurant. Then a member of the company is presented an opportunity to invest in another restaurant.
Sometimes a member or manager having competing interests is acceptable. For example, a member is in the business of investing in restaurants. If the competition is acceptable, the company agreement should say so.
Sometimes, however, such competition is not acceptable (for example, the company’s two members started a restaurant together and expect to devote 100% of resources and time to the business). If this is the case, set ground rules for competing activities. Consider requiring the member to provide notice of such opportunity to the managers of the company and allow the managers to affirmatively decide to allow the member to pursue the opportunity or to have the company pursue the opportunity. You might also address a management deadlock as described in mistake 4 above.
Mistake 5: Failing to prepare for a business divorce.
We’ll talk more about the specific options in an upcoming article, but it is always good to have an exit plan. There are a variety of ways for members to negotiate buyouts and procedures for business divorce ahead of time. These “exit strategies” must be balanced with appropriate restrictions on a member’s transfer of its interests.
Consider including rights of first refusal, drag-along rights, tag-along rights or put-call options in your company agreement. Depending on the specific circumstances of the company, these provisions provide guidance on offers to buy or sell membership interests, valuation, notice and timelines for purchase or sale (among other things).
Address these potential mistakes at the outset.
Learn from others’ mistakes and your attorney’s experience. It is much easier to address these potential mistakes at the outset, when the parties are typically getting along. Waiting to address issues when they arise (and the parties aren’t so friendly) will make negotiations more difficult and costly.
Disclaimer: This article is not a substitute for legal advice. Every situation is different; you should not rely or act upon the contents of this article without seeking advice from your own attorney. Use and access to this article or any materials or information provided herein do not create an attorney-client relationship between you and Christine Stroud, PLLC d/b/a Fincher Stroud Law, PLLC (the “Firm”). By providing public access to this article, the Firm is not purporting to solicit or render legal or other professional advice or opinions on specific facts or matters, and the Firm is not creating or intending to solicit or create an attorney-client relationship between you and the Firm.