Business Agreements 101
Legal agreements are used to structure business entities including the manner in which owners invest money, manage the company and allocate profits. This article focuses on business agreements for partnerships and limited liability companies ("LLC"), although there are many other forms of business entities. LLCs are a hybrid form of partnership in that the owners of the company ("members") have limited liability like a corporation but often enjoy the flexibility of partnership tax treatment.
Both partnerships and LLCs require at least one legal agreement to govern the rights and responsibilities between the owners. In general, the governing agreement for a partnership is called a "partnership agreement" , whereas the equivalent agreement for an LLC is called an "operating agreement". The difference between a partnership agreement and an operating agreement is merely a matter of law. In New York, for example, the legal requirements for a partnership agreement are set forth in the New York Partnership Law, whereas the New York Limited Liability Company Law governs LLC operating agreements.
Just like every business is different, the needs for each partnership and LLC will differ, and therefore each business will require a custom written governing agreement. However, there are "standard" provisions that can be tailored to a specific company.
What is a Partnership Agreement?
A partnership agreement is a binding contract between general partners in a business marks the creation of a partnership. The purpose of a partnership agreement is to outline the obligations, rights and privileges of partners within the company. It outlines how profits are distributed and work is done. Rules to how day-to-day operations are conducted are included. A partnership agreement also sets forth rules and guidelines to how partners exit or join into the agreement. There are several major components that every partnership agreement should contain.
One of the most significant components of a partnership agreement is how profits are allocated. This section generally describes level of ownership within the business and how shares of profit are divided. Frequently, partners in a business will share an equal amount of shares. In some instances, partners may have contributing cash or property to the business to acquire a greater share within the business.
A partnership agreement can outline how new partners can be added to the agreement by both existing partners. This section generally discusses the terms a new partner must meet to join and specifically how much investment a new partner must contribute.
An exit clause is the section that outlines how an existing partner leaves the business. Like an addition of a new partner, the exit clause has specific terms that must be met by an exiting partner. This clause includes sell-back provisions, including buyout price, the rights of remaining partners to dissolve the business outright, including other options, and payment terms.
Contingency plans are discussed in the agreement, as well. These plans provide for potential disasters or other crises events. The agreement may provide for the dissolution of the agreement in certain events, insurance policy details and ways in which agreements can be canceled. An attorney can explain the various forms of business organization that you may wish to consider aside from a general partnership.
Understanding Operating Agreements
The next type of agreement we’ll look at is the operating agreement. An operating agreement is the document that an LLC adopts to describe the ownership and operating procedures of the LLC. The operating agreement is the governing document of the LLC. It describes the members of the LLC, what their ownership interest is in the LLC, how profits and losses will be allocated, what happens if a member wants to leave the LLC, and what happens if a member of the LLC dies. In most cases an operating agreement is needed when there are multiple members of the LLC.
Whether a single-member LLC needs an operating agreement is questionable. Generally, an operating agreement is considered an internal document, so no one but the members/or managers of an LLC need to review it. But it is beneficial to have for organizational purposes. It is critical that the operating agreement be properly adopted. A court may not enforce a member’s rights if the operating agreement is not adopted. Typically, when forming an LLC, the operating agreement will be signed as part of the organizational documents.
Partnership Agreement vs. Operating Agreement: Major Distinctions
Partnership and operating agreements both function as vital legal documents in the world of business formation, but there are key differences between the two. Partnership agreements will only apply to partnerships. Specifically, general partnerships have partnership agreements, limited partnerships do not have them, and limited liability partnerships do have them. On the other hand, the operating agreement is the exclusive domain of limited liability companies (LLCs). One of the major differences between partnerships and LLCs that could be critical to you is that an LLC does provide its owners with limited liability. A limited liability company is similar to a corporation in that its owners or shareholders are shielded from personal liability. In short, partnership agreements are the sole domain of partnerships, and operating agreements are the sole domain of limited liability companies.
Legal Requirements and Flexibility for Both Agreements
When forming a limited liability partnership (LLP) or a limited liability company (LLC), both partnership agreements and operating agreements can be utilized to govern the internal structure of the business. However, the legal requirements for creating these agreements as well as the associated flexibility can differ.
LLCs are required to have an operating agreement. Although all states do not necessarily require an operating agreement be in writing, having a put agreement into writing is still highly recommended. The primary reason being that oral contracts are difficult to enforce and could lead to unwanted outcomes. Since the LLC is a separate legal entity, even if it is owned by a single shareholder, the company is still required to have an operating agreement and stay in compliance with all the legal requirements for LLCs.
The flexibility of LLCs is one of the main advantages of the entity itself . The owners of an LLC have more operating flexibility than those of other entities. They can be as specific or as open ended as they like. Once the LLC adopts the agreement, it becomes binding on the owners. In this case, the owners really are bound by its terms and the LLC is dedicated to following it.
Unlike LLCs, having an operating agreement is not legally required for an LLP; however, it is advisable to have one. A written partnership agreement allows for more control and flexibility for partnership owners and protects the owners’ overall interests. Even though an LLP may not be legally required to have a written agreement, partnership owners may still need to lay down their rules and regulations and put them in writing. The agreement can have strict rules or can allow for more flexibility than an LLC. What is most important is that the owners of the LLP put everything in writing and have the actual agreement be reviewed by a professional.
Selecting the Right Agreement for Your Venture
Once you have the basic understanding of what a Partnership Agreement and an Operating Agreement are, how do you know which you need? Or do you need both? Well that depends on your company’s structure. Is your company a C Corporation or an S Corporation? If it is a corporation then you need corporate documents. If your company is a general partnership, then you can have a Partnership Agreement. An Operating Agreement is something used by Limited Liability Companies (LLC).
If your company is an LLC with two or more members, you should definitely have an Operating Agreement. And if it is a single member LLC, you could either have an Operating Agreement or a Sole Proprietorship will suffice. If your company is a corporation, your bylaws will likely serve as the operating agreement for your company. Bylaws are essentially the rules and regulations that govern a corporation. A C Corporation will have bylaws while an S Corporation may have bylaws or an Operating Agreement.
For small businesses with no future plans to seek outside funding, a Partnership Agreement is probably all that is needed. However, LLCs can be structured for any situation and can protect your personal assets, even if you decide to seek some type of outside funding.
Common Mistakes and Other Factors to Consider
The most common trap I see, particularly with clients executing a partnership agreement, is not engaging in meaningful discussion with the partner. I have seen many agreements where a 40 page document has been committed to writing and signed, yet both parties have no idea what the other is doing, where the companies will be in 5 or 10 years and what each role is in the company. The agreement is meaningless and there is still the potential for future litigation.
Also, I’ll add that neither a partnership agreement nor an operating agreement will account for everything, so it’s not a substitute for having a company-wide strategic plan. Your plan should be more like the 25,000 foot overview of who your company will be in the future, and the agreement is essentially a legal document memorializing all of your plans.
Some other common pitfalls:
- Not understanding the difference in the formation process and requirements (state and federal tax purposes, regulations) between an LLC and a Corporation.
- Not accounting for future dilution.
- Poorly drafted shareholder buyout provisions. A drag-along clause is particularly important to avoid future equity issues.
- Not having provisions regarding conflict/divorce. It’s relatively common for one spouse to file for divorce, claiming "the business is making too much money" for instance. This often is used to get a 50% ownership interest, even though the couple has no intention of pursuing that business either together or as joint owners. Having a provision in place that addresses this situation will be necessary to avoid litigation.
Also, MBEs and WBEs may not even know that a joint venture may be appropriate in their case. These types of businesses need to do their research with respect to requirements to maintain MBE/WBE certification and what structure(s) may be appropriate to satisfy those requirements.
Final Conclusions and Thoughts
In closing, we’ve covered some of the differences between partnership agreements and LLC operating agreements. In summary, a partnership agreement is typically a contract between two or more people or entities operating a business as a partnership. An LLC operating agreement is the same type of contract but for a limited liability company rather than a general partnership.
In deciding whether your business needs either of these documents, consider its size and complexity . LLCs engaged in multi-state business or that have a combination of owners and managers may benefit from the structure and flexibility offered by an operating agreement. Partnerships that provide for the transfer of ownership in the event of a partner’s retirement or incapacity, for example, should have a partnership agreement to address these and other issues.
In short, the success of many businesses depends on having a clear and legally enforceable agreement governing all aspects of the company. Investors, lenders, owners and employees need and want the protection that clearly written and enforceable agreements provide.