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.
Organizational
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.
Organizational Purpose
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.
Member
Information
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.
Management
Information
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?
Officers
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.
Record-keeping Requirements
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.
Financial Affairs
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.