The most common entity structure for new companies today is, not surprisingly, the limited liability company (“LLC”). And, there’s good reason for this trend – when compared to corporations, LLC’s are easy to setup and require far less in terms of on-going maintenance and legal requirements.
However, the ease of setting up an LLC can lure business owners into a false sense of security, causing founders to overlook important formation issues. This is particularly true when LLC’s are set up through on-line filing services that claim to help you “start a company” for $99. These filing services will gladly take customers’ money, and complete rudimentary boilerplate forms and then file those forms at various state and federal agencies without any legal advice, this leaves founders with the misconception that all of their legal needs in forming the company have been met.
This is the first of several articles outlining the most costly and avoidable errors made by entrepreneurs and founders in the LLC formation process, particularly when using on-line filing companies to form an Oregon LLC.
#1. No Operating Agreement
Filing of Articles of Organization with the state of Oregon’s corporation division is the first step in establishing an LLC, and on-line filing companies will often lead customers to believe this is all that is required to set up a company from a legal perspective. In almost every case, much more than Articles of Organization is required to properly set up a company, and a well-prepared Operating Agreement is essential.
Without an Operating Agreement, the LLC is essentially a shell structure – established by filing the Articles of Organization – without anything specific to govern the internal workings of the company aside from the Oregon Limited Liability Company Act (“LLC Act”). While the LLC Act is great for its flexibility, it is vague on many legal questions, leaving your company with no clear path to resolve issues when they inevitably arise in the course of doing business.
The LLC Act is a general, one-size-fits-all source of rules to govern Oregon LLCs. But in most situations, the LLC Act provides only “default rules”, meaning they are not mandatory and only apply when the LLC itself hasn’t provided an answer. With an Operating Agreement, founders have the ability to address as many legal issues and potential situations as they desire, provide certain outcomes, and avoid costly litigation down the road.
For example, the LLC Act provides no concrete guidance on what happens when owners of an LLC decide to part ways – can the departing owner sell to anyone they choose? Must the LLC purchase her stake? How is the departing member’s interest valued? – these questions are left unanswered by the LLC Act. With an Operating Agreement, owners of an LLC have the opportunity to provide clear answers to all these questions from the start. Failing to do so will inevitably result in the LLC’s owners paying a premium to lawyers, mediators and accountants to resolve the issue when it comes up.
For multi-member LLCs where there is more than one owner of the company, it is particularly critical to have a properly drafted Operating Agreement. Here are just a few examples of the legal issues that a well-drafted Operating Agreement should address for an Oregon LLC:
1. Transfer of ownership provisions – will there be restrictions on who an owner can sell their interest to? Will the LLC or remaining owners have a right or an obligation to purchase a departing member’s interest?
2. Valuation of departing owners’ interest.
3. Procedures for admitting new members.
4. Is one owner responsible for day-to-day business decisions?
5. Procedures and restrictions on additional capital contributions.
6. Deadlock provisions – particularly important when there are two owners, each with 50% of the voting rights.
7. Voting issues, including a definition of matters requiring majority vs. unanimous vote.
8. Non-competition – can members start or operate other companies?
9. Member duties and obligations to the company.
10. Meeting provisions.
There will be many legal issues and mistakes that founders of any company will make throughout the lifecycle of the business. Those issues will be dealt with on a case-by-case basis as they arise, but having an Operating Agreement in place at the outset will help minimize those issues significantly.