4 Types of Legal Documents that Every Private Company Should Have Setup for Protection
Zana Tomich, a partner of the law firm Dalton & Tomich, PLC, wrote an interesting article on CFO.com, where she explains “that every business should have certain vital documents in place, such as bylaws and records of ownership, and buy and sell agreements.”
To use the metaphor that keeping your home clean and tidy is an important step in creating a successful home living environment. The reason being is because when everything is in order, things tend to operate more smoothly. And in the business world, both startups and privately-held small businesses must also keep their proverbial “houses” in order. But what does that mean?
In the CFO article attorney Zana Tomich makes the argument that there are crucial documents that every company should have in place to:
- Steer it in the right direction
- Guide it through disputes
- Avoid legal pitfalls
- Setup the corporate legal armor that shields owners from exposure personal liability issues
On top of all that, the legalese in these documents is also important for other reasons such as raising Seed Round or Series A investor capital, positioning the company for an exit or M&A sale, and complying with any lender document requests. There are also tax considerations to be aware of when choosing a particular business entity selection when launching a new startup.
Every company should have certain vital documents in place to steer it in the right direction, avoid legal pitfalls, guide it through disputes, and establish the corporate veil that protects owners from exposure to personal liability. The information in these documents is also critical for positioning a company for sale, raising capital, and complying with lender requests.
Here are 4 documents that an investor-backed or privately held company should have soon after the business entity is formed
1 Operating Agreement or Bylaws
(image credit: score.org)
Which should document the rules by which the company operates. For example, In a limited liability company (LLC), an operating agreement indicates the members, rules by which the company will be managed, defines the internal operating procedures, capital contributions already made and to be made, and the distribution of profits. Some may include provisions preventing the sale of memberships to third parties or laying out procedures for resolving disputes between members. Getting these rules set up or documented (or making time to update them) is important if the company ever gets sued, a member dies, or members decide they can no longer work with one another.
Ms. Tomich also points out that similarly, in a corporation, bylaws are internal governing documents that set out the company’s rules and regulations. They provide guidance on the officers the company will maintain, the duties of each, voting mechanisms for the board of directors, and the rights of shareholders. How decision-making is conducted, including who must be present to make decisions, is also addressed. These provisions are also important in a dispute, a sale of the company, or a major action such as acquiring another company or obtaining financing.
2 Records of Ownership and Transfers
(image credit: Berkeley Media)
Ms Tomich points out that in the past or historically, keeping track of ownership and transfers of a company was done on a stock ledger. Many corporate entities still maintain one. With the advent of limited liability companies and the de-formalization of companies’ organizational structures, however, ownership records often slip through the cracks. In many privately held companies, it is clear who owns what. The issue can quickly get complicated when shareholders or owners pass away, get divorced, or when employee shareholders leave the company without giving up their shares.
A key point is that transfers should be clearly documented through assignments and consent resolutions affirming the transactions that took place.
3 Records of Loans and Company debts
If you have ever watched an episode of the CNBC, show Sharktank, when the sharks will as the startups about ownership structure they will also ask if the business has any loans or debt which it owes money to creditors. The owners of a privately held company will often do anything to keep the company afloat during economic downturns, including loaning funds to the company. When this happens, it is important to document such transactions with promissory notes or other loan agreements. Having these documents is crucial when one owner, member, or shareholder makes a financial commitment and expects the company to repay them. Having all financial records evidencing loans and other transactions between the company and its owners keeps everyone on the same page — and makes it more likely financial obligations will be met.
4 Buy and Sell Agreements
(image credit: Ketel Thornstonsen LLP)
What will happen if one of your business partners decides to retire early, has an accident and can’t work, or just decides to sell? Will you suddenly be running the company with a spouse, a stranger – or even a competitor? Suppose your partner passes away unexpectedly; his or her part of the business could be tied up in probate for six months to a year or more.
These nightmare scenarios do happen, that is why Ms Tomich recommends that every privately-held company (especially if it is going to take on investors) should have a buy and sell agreement document drafted up with help of an attorney. Sometimes referred to as a shareholder restriction agreement, this document prevents shares from being sold outside the control of a privately held company.
It can also provide a mechanism to address the company’s future, what happens when a key employee leaves the company or retires, or if an unexpected departure, disability, or passing occurs. Buy and sell agreements also address the value of the owners’ interests in advance so that there is no dispute as to what the buyout price is at the time of departure.
The Hartford wrote an article about this topic, where they state “for example, what happens to the departing owner’s interest? Will the remaining owner or owners buy that stake? Perhaps there’s a mutually agreed-upon person who will step up. Or, the owners may want to put restrictions on sales to outside parties without unanimous consent. Then, there’s the purchase price. How will the business be valued – and how will it be paid for?”
Having a buy and sell agreement in place helps a business operate through uncertainty and continue for future generations.
When it comes to creating, updating, and accessing key documents, private company needs are not of the same complexity as those of a publicly-traded entity. However, the issues are no less important.
So along with having the proper documents mentioned in this article, to set up your company for protection and success it is equally crucial to have the right accounting and back-office systems in place. Most companies are created to provide a product or a service, but obviously, there’s a lot more that goes into a business than just making and selling that product/service. From getting your brand in front of potential customers to making sure your taxes are being paid, there’s a whole range of supporting work required to keep your company running. Sometimes it can make sense to outsource some of these functions such as bookkeeping, payroll, CFO, or controller services. Huckabee CPA advises and works with dozens of startups and small businesses in California, feel free to reach out with any questions or for a consultation.