Essential Provisions: Module 2 of 5
Module 2: Essential Provisions
In the first module, we introduced business governing agreements and how they apply to three of the most common forms of companies: corporations, limited liability companies and partnerships. We considered questions including the advisability of having a governing agreement, whether state law can require a business entity to have one, and whether the agreement should be oral or in writing.
This module builds on that introduction to examine necessary and advisable provisions that written governing agreements for each of these company types should have. These fall into three general categories: organizational information, member information and management information.
Governing agreements establish contractual relationships among the members of the business. They are not intended for use or reference by third parties. With a handful of exceptions, state governments do not require filing them with the Secretary of State’s office to prove the creation or current good standing of the company. Still, to prevent misunderstandings that could have a legal impact on the organization, it is good practice to include, at the beginning of the agreement, information that helps insiders and outsiders understand some of its characteristics.
This section describes the “why” of the company: the motivations or reasons for which it is established and does business. The purpose statement commonly includes: identification of the company, its legal entity status, the product or service that it provides and its targeted customers. It is usually short, consisting of a sentence or two of no more than 20 to 25 words.
Organizational purpose statements are similar to, but distinguishable from, vision statements (what the company aspires to become or to provide in the future), values statements (the internal culture the company seeks to create) and mission statements (descriptions of the company’s place in its market or industry that serve to narrow its focus). Organizational purpose statements focus more on what the business does or how it does it as opposed to answering questions such as why it was founded, why it is in a particular field and why it serves its customers.
Examples of organizational purpose statements may include:
- For an insurance company: “To help people manage risk and recover from the hardship of unexpected loss.”
- For a communications equipment company: “To provide a mix of value-added, accessible communications products and services to consumers who are deaf, hard-of-hearing or speech-impaired.”
- For a nonprofit animal welfare organization: “To provide effective means for the prevention of cruelty to animals throughout the United States.”
- For a nonprofit medical clinic: “To provide better care of the sick, investigation into their problems and further education of those who serve.”
Purpose Statements and Third Parties
The organizational purpose statement is one example of how a business governing agreement can interact with third parties, particularly regarding nonprofit organizations. Federal IRS regulations limit the types of businesses that qualify for nonprofit tax-exempt treatment. A purpose statement that corresponds to one of the nonprofit categories the IRS recognizes can be helpful if the IRS challenges the company’s nonprofit status.
State laws recognize corporations and LLCs as "persons," but these organizations do not exist independently of the people behind them: shareholders for corporations, and members for LLCs (which can include other corporations, LLCs, partnerships, associations, and individuals). One important benefit of doing business as a corporation or LLC is that the entity can shield the people behind it - and their assets - from liability for acts of the company. The business governing agreement's member provisions help identify those people as well as their rights, responsibilities and roles in the company. In this respect, the agreement serves as an internal charter and as evidence for third parties about the members' protected legal statuses.
What must be included in the member section of the governing agreement and the degree of detail depends on the form of the business. In Module 1, we observed that companies must operate within a range of state law protections and record-keeping requirements and must observe more intrusive government-imposed duties as their legal person status becomes more formalized. Partnership agreements are the least formal, corporations the most, and LLCs are in between. Thus, corporations’ shareholder provisions tend to be more comprehensive than those of partnerships concerning the partners.
Regardless of the business form, the governing agreement's member section must include the following:
- Identification of initial members, their contributions and proportional share of ownership of the business, as well as procedures to admit new members and to provide for the end of membership through sale or other transfer of interest or by the termination of that interest.
- A description of member rights. The most important member right is the right to vote at annual or special meetings, either in person or by proxy. The agreement can describe the voting rights of members generally, or by class (such as when a corporation has more than one type of share). Other member rights can include the right to inspect the company's financial records, to receive notice of member meetings and to have the company indemnify members against legal liability arising from acts they take on behalf of the company.
- A description of members’ duties to the company. This takes the form of a statement obligating members to perform their duties in good faith and in a manner they reasonably believe is in the best interests of the company. Note, however, that even if the agreement does not expressly state member duties, members still have implied fiduciary duties to the company and to other members by law, particularly if the member has management duties.
Before they draft the governing agreement, the company members must decide how they want the business to be run. Will the members play a direct role in management, or will they create a separate management structure? Considerations here include:
- What is the form of the business? If it is a corporation, state law will likely dictate that it must have a board of directors even if the organization is small and the board consists of only one person. Other organizations, like LLCs and partnerships, are not subject to this management superstructure requirement.
- What are the members' preferences? Do they see the enterprise mainly as an investment opportunity in which they have little interest in assuming operational responsibilities? Or are they hands-on entrepreneurs who want to be closely involved in business decision-making? Do any of them have special experience or expertise without which the business cannot function on a day-to-day basis?
- What is the size of the business? For example, if the company is small, such as a two-member partnership or a single-member LLC, it may have little choice but to combine membership and management roles.
Depending on the answers to these questions, the agreement's management section can be succinct (for example, "Management of this company shall be vested in the Member" for a single-member LLC), or considerably more elaborate. We will explore some of these more detailed management provisions later.
Board of Directors
The board of directors is the body primarily responsible for managing the affairs of the corporation. Although an LLC operating agreement can establish a board of directors, this seldom happens because it runs contrary to one of the reasons for choosing the LLC business form - simplicity of management compared to a corporation. In establishing a board of directors, the governing agreement - bylaws, in this case - should consider the following elements:
- How many directors should there be?
- What will be the enumerated powers of the board, such as whether it can amend the bylaws?
- How will the company appoint its initial directors, how long will they serve, and what will be the procedure to elect new directors?
- How often will the board meet? Similarly to shareholders, the board will need to have at least one annual meeting and may call additional special meetings. Also, what notice is required for director meetings, and can notice be waived?
- What matters will the board address in its meetings?
- Will the company compensate the board members? If so, how?
- How can board members voluntarily leave the board before the expiration of their terms? How can they be removed from the board, and by whom? How will the board fill director vacancies?
- Can the board appoint committees? If so, what is the procedure for doing so?
Although the board of directors is the primary managing authority of a corporation, it does not normally run the day-to-day matters of the business. This is the role of the corporate officers. The bylaws ordinarily contain sections dedicated to identifying the officer titles and duties (which usually include, at a minimum, a president, one or more vice-presidents, a secretary and a treasurer), how the board selects officers and their terms of office, how to remove an officer early, how to fill a vacancy and officer compensation.
Additional Management Provisions
Creating the company's management organization establishes the foundation of a governing agreement. The drafters of the agreement must next decide which additional management-related sections to include to create the framework within which management will work.
Businesses generate records, including minutes of meetings, resolutions, identifying information for members and employees, contracts, permits and licenses, leases, payroll and personnel records, accounting and tax information and more. The governing agreement usually includes a provision requiring that the organization keep these records at its registered place of business or another specified location. This section can also include the company's policy for routine periodic destruction of records.
The governing agreement can set the requirements and procedures for how business members can take money out of the company in the form of dividends or distributions, and who is authorized to draw on the company’s financial accounts.
Amending the Governing Agreement
As with any written contract, having a provision controlling how the business members can change its terms and conditions will help avoid misunderstandings that could lead to conflicts within the business.
Dissolution of the Company
As in the case of who is authorized to declare dividends or authorize distributions from the company, the governing agreement's directives should include direction on who in the business is authorized to dissolve or wind up the business. If unanimous consent to dissolution is not necessary, this section should state the proportion required to approve it (such as by two-thirds vote of the shareholders). It should be noted that dissolution is a “fundamental” change to a corporation and so, by rule in many states, must be approved by the shareholders rather than by the directors alone.
How Detailed Should a Governing Agreement Be?
A business governing agreement's sophistication and page count can vary considerably based on how many organizational, membership, and management sections the business owners choose to include. The creators of new businesses must consider how the level of the governing agreement's details matches their needs and their capabilities.
Multiple factors determine which form of governing agreement to choose and how comprehensive it must be. Some of these are the same factors that influence the company's members in choosing the form of the business: the more complex the organization and its environment, the more likely it will need a business structure and governing agreement to match. Two people who want to jointly open a local florist shop may have little use for bylaws requiring them to have a board of directors, officers and annual meetings for each, while a large company that seeks to manufacture components for military jet engines may require considerable shareholder financial support along with multiple officers and departments for which a partnership agreement or LLC operating agreement is not ideally suited.
Another consideration for small businesses like partnerships and LLCs is that even though it can be tempting to draft a "kitchen sink" governing agreement that includes as many sections as possible, this is not always necessary or advisable for two reasons:
- First, many small business owners want or need to be more involved in running the company than merely being its administrator. The more time they must spend paging through the governing agreement attempting to comply with detailed requirements and restrictions, the less time they have to be involved in running the operation of the business.
- Second, for a small company governing agreement it is possible to have "too much of a good thing." If the owners do not have the time or inclination to adhere closely to a lengthy and detailed governing document, the more likely it becomes that they can expose themselves to internal conflict or even legal liability if they overlook or inadvertently violate the agreement's requirements.
The contents of the governing agreement depend on the type of legal business entity, how many business owners there are, how well they know each other and what their business objectives are. Especially for more formal business organizations, having the assistance of an attorney when drafting the governing agreement can help ensure that the governing agreement's contents most closely match the needs of the company.
In this module we have explored the three most common forms of governing agreement and the provisions that all of them should include. Although it is possible to create "hybrid" agreements that do not fit precisely into any of these three agreement types - such as a partnership agreement that provides for officers or an LLC operating agreement that requires the equivalent to a board of directors - in most situations one of the three basic agreement types will suffice.
In our next module, we’ll look at how both model and state laws affect governing agreement content.