Module One: Introduction to Business Governing Agreements

In any joint endeavor, whether it’s children getting together to build a tree house or entrepreneurs and investors establishing a multi-million-dollar business, human experience teaches us that “making up the rules as we go along” invites uncertainty, discord, power struggles, mission failure, and the eventual dissolution of the group. The more people involved in such an informal effort, the more likely these undesirable consequences become.   

What enables successful collaboration is having rules: at the societal level, we have written laws and regulations. At the business level, rules take the form of business governing agreements. This module explores questions about the role a governing agreement can play in a company and whether and when these are necessary.

The Functions of Business Governing Agreements

The term “business governing agreement” describes collectively the types of documentation companies use to set forth the rules under which they operate. In addition to establishing the organization’s rules, these agreements lay out procedures for matters including elections, meetings, and implementing decisions. A governing agreement can also identify what obligations the owners have towards each other, and whether members can take legal action against one another in case of a breach of the agreement.  

Depending on the type of business, governing agreements take different forms and go by different names. The three most common are corporate bylaws, limited liability company, or “LLC” operating agreements and partnership agreements.      

We also must distinguish business governing agreements, which address how the business works, from business establishment documentation, such as articles of organization or incorporation, which have no direct effect on the company’s operations. These may be required by state law to commence operation of the business but are beyond the scope of this course.

Why Have a Business Governing Agreement?

            Having a business governing agreement benefits a company in two related ways: it avoids problems inherent in not having such an agreement and gives the principals control over the operating rules and procedures best suited to meet the business’ needs. Let’s consider some of the reasons why having a governing agreement makes for good business practice.

In the case of a sole proprietor (that is, a business operated as an individual under his own name or a “doing business as” name), the only person the sole proprietor is accountable to is himself; there is no one else with whom to enter into a governing agreement. In this case, having a governing agreement is probably unnecessary and does not confer the same advantages it can with a more formal business structure.

Aside from the sole proprietorship, even though one may not legally be required to have a governing agreement, it is still prudent to have one.  

1. A Governing Agreement Supports Protection

One of the reasons to create a company as a legal entity is to limit potential personal liability for things you do in connection with your business. This protection is not automatic nor absolute, and for corporations, in particular, one needs to take specific actions to preserve it. More so even than LLCs or partnerships, a corporation must maintain the “legal fiction” of being a separate person, and this means observing the formalities of corporate status: holding regular meetings, maintaining minutes of those meetings, keeping the corporation’s funds separate from your own and having bylaws. A lack of bylaws, or oral instead of written bylaws, makes one more vulnerable to “veil-piercing” attacks by people who would have a court disregard the company’s entity status so they can seek personal liability against the owner.

2. A Governing Agreement Helps to Avoid Management Problems

Even if one is not required to have a governing agreement, such an agreement can still serve as a valuable “insurance policy” against internal conflict and gridlock. Rare is the business that never experiences disagreements among its owners about how to run it; even husband-and-wife business partners can still have serious business disputes. Not having any governing agreement, even an oral one, to anticipate and diffuse internal conflicts is an unforced error that can lead to bad outcomes up to and including the demise of the business itself.

3. A Governing Agreement Helps Others to Do Business with the Company

If there arises a need to obtain assistance with a company’s operation, such as applying for a business loan, many lenders will ask for a copy of the governing agreement and other documentation to verify information such as the business name, who the business owners are, their ownership percentages, whether they should be named as loan guarantors and whether the applicant has the authority to bind the company in financial transactions.

When Business Governing Agreements are Required

Business legal entities are artificial persons -- they are creatures of the state. They live only because state laws authorize their existence. If one takes advantage of a legal entity status when forming one’s company, this will subject the company to government-imposed requirements in return.   

Understanding in advance how invasive the government’s involvement can be in overseeing the way the company is run can help managers make informed decisions about what legal entity status to use. As a general rule, the more formal the business structure, the greater the extent of government intrusion into it. For example, creating a corporation will open the door to considerably more government-imposed requirements and restrictions than forming a partnership.

In any business form, the first question to ask is, “Does the law of my state require me to have a business governing agreement?” For corporations, the answer is “Yes.” State corporation laws commonly include directives such as, “The incorporators or board of directors of a corporation shall adopt initial bylaws for the corporation.”[1]

In the case of an LLC, less uniformity exists. Some states, like California[2], Missouri[3] and New York,[4] require LLCs to have operating agreements, either written or oral.  Others do not require operating agreements, but mandate that they must be in writing if they exist,[5] while still others have no operating agreement requirements. In the case of general partnerships, having a partnership agreement is always optional.

Govern or Be Governed 

Some businesspeople downplay the importance of administering their businesses in favor of “running” the. To them, time spent thinking about meetings, elections, resolutions, and the like is time taken away from marketing or managing so, even if they have governing agreements, they see them as necessary evils and devote as little time as possible to their creation and maintenance. This can be a mistake, particularly in states that have statutory governing terms that take effect in the absence of an agreement.

A saying goes, “If you don’t have a plan for yourself, someone else will have one for you.” This is as true for a business as it is for a person. If there is no governing document, many states have “one size fits all” default rules that take effect in that absence.

These rules can be state-specific or based on uniform acts like the Revised Uniform Limited Liability Company Act[6] or the Uniform Partnership Act.[7]

State law default provisions can be simple or detailed. For example, for an LLC, state law default rules can include the following:

•         The liability of a member or manager for the LLC’s debts, obligations and other liabilities.
•         A member or manager’s authority to lend money to the LLC, transact other business with it and inspect the company’s records.
•         The company’s ability or responsibility to indemnify a member or manager for acts that person takes on behalf of the LLC.
•         Member obligations to the LLC (cash or property contributions, or services), member rights to distributions from the company and restrictions on those rights.
•         Procedures for admitting new members and transferring membership interests, member dissociation from the company and removal of members.
•         Establishing classes of members and their voting rights as well as their abilities to delegate their rights to others.

        Potential drawbacks of relying on default state law governing provisions include:

•             It can be a time-consuming chore to wade through state statutes to learn what your governing rights and boundaries are. The relevant laws may be spread among several codes, chapters and sections, increasing the possibility of missing a key provision.
• ·           A company may be forced to adopt management practices that it does not want.
• ·         Even if one is content with the default provisions, the business would be subject to changes in state laws that can affect how the business is run.[8]
•             A company that seeks to retain maximum control and flexibility in how it is run should consider putting its own governing agreement in place. State default laws typically subordinate themselves to provisions in a company’s governing agreement as long as those differing provisions are not illegal.

The Written Agreement

Assuming the company decides to make its own business governing agreement, and assuming further that its state allows for oral and written governing agreements, the next consideration is whether to put the agreement into writing. Taking the extra (sometimes costly) step of putting the agreement in writing provides significant benefits, including:

•             Having a written governing agreement can immunize the company against the avoidable risks of verbally-based arrangements, like real or perceived arbitrariness, unfairness or faulty or selective memory.
•             Aside from serving this protective purpose, if there arises a dispute between managers that requires a third party to help resolve, a written agreement is more authoritative, less subject to misinterpretation and easier to prove.
•             Especially if the business is a corporation, if an outsider challenges the existence of the company, then having a written governing agreement reduces the risk of a court disregarding the legal entity status as a sham or “alter ego” and treating the business – and its owners – as a sole proprietorship or partnership.
  

Before beginning the process of writing the governing agreement, it is a good idea for everyone involved in running the business to agree on a common vision for the enterprise. For example, the choice of legal entity will bear on the type of governing agreement needed (bylaws, operating agreement or partnership agreement).

Once the form of the business has been chosen, the company can focus on the important details to be put in writing. What will be the status of the initial stakeholders (members, shareholders, partners)? Will they participate equally in the operation of the company, or will the company have classes of owners based on their ownership shares and management involvement? Should the agreement define the roles of the managers and officers? How will the company manage membership growth? The more that is agreed to in advance, the more likely it is that the governing agreement will reflect the founders’ shared plans and goals and the less likely it will be that something will be left out that will require a later amendment to the agreement.

Available Drafting Resources

Corporations, LLCs and partnerships have existed for a long time, so one has a wealth of others’ experience to draw on when modeling one’s governing agreement. Working with an attorney who knows the business laws of the state is one option, especially if the business is going to have many stakeholders and layers of ownership and management.

If the business plans to start small and with a comparatively simple organization, there are many websites that provide step-by-step instructions for the creation of a basic, fill-in-the-blanks governing agreement template that can be saved and printed. These online services vary in their degrees of comprehensiveness; some offer to help create an agreement for free, some charge nominal fees and some can be a bit more expensive.

One can also search for other companies’ governing agreements and use them as models for their own documents.

If one chooses to forego consulting with an attorney in writing the agreement, it is still sound practice to have another person review the draft agreement to make sure that it is not missing any important provisions, that the agreement does not contain any passages contrary to law or public policy, and – especially if using an online template – that the agreement conforms to the laws of the state.

The business governing agreement is a legal document, a contract that is binding on its parties. It is not, however, something that must be filed with the secretary of state’s office along with the business establishment documents. The company should keep its governing agreement, along with any modifications to it, on file at the company’s place of business for quick access by anyone who needs it.

Conclusion

There are many things about creating and running a business over which one has little or no control, like market conditions, competition, and government laws and regulations.  Having a business governing agreement, preferably in writing, is one way to avoid overly-general statutory defaults, bolster legal protection, and customize the administration of a business.

Later modules in this course will examine specific considerations that go into preparing a governing agreement, including essential and optional terms, enforcement of the agreement, and the differences among corporate bylaws, LLC operating agreements and partnership agreements.