Businesses with More Than One Owner
As freelancing evolves, more and more people who identify themselves as freelancers are thinking about joining forces to do business together, either informally through closed networks, or as formal co-owners of a legal entity. Running a business with other people has plenty of advantages. Partners can divide the expenses and administrative work associated with running the business, and leverage their distinct talents to build a stronger brand. Businesses with more than one owner are also inherently more complicated than solo businesses, enough that it is beyond the scope of this book to address all of the important issues that business partners need to address when organizing their business. This chapter briefly introduces the business entity forms that are commonly used by businesses with multiple owners, including extra considerations for LLCs and corporations. We’ll also review some of the core ideas that business partners need to resolve when organizing a legal entity.
Two Points about Business Partnerships
Before we dig into the legal entities themselves, let’s think about a couple of topics that don’t come up for solo business owners: looking after your own interests in a partnership context, and the obligations joint owners owe to one-another.
Protecting Yourself
When going into business with others, it is vitally important to protect your own interests. No one else will do that for you, and that includes the lawyer the business hires to draft the company’s paperwork. When a business hires a lawyer, the lawyer is required to treat the business itself, not its owners, as the client. Although the owners have plenty of say about how the business is organized, the lawyer can’t separately advise each owner about how their rights might be affected by the decisions made in connection with organizing the company. A good business lawyer will advise the owners to seek their own, independent counsel on the potential legal, financial, and tax implications of forming a business.
A big reason for taking steps to protect yourself is the risk that the business won’t succeed, or worse, your partner will turn out to be unethical or downright criminal. In a very small business, chances are good that everyone involved will have some degree of authority over the company’s assets, including bank accounts. It is important that the company’s organizing materials address problems like insolvency before getting started.
Think of the company’s organizing documents like a prenuptial agreement. The business partners might love each other at the beginning, but if things go badly, or one of the partners runs off with the company’s pot of gold, the company’s legal framework will provide an important tool for managing not just business risk, but your personal risk as a partner of the business.
Obligations to Your Partners and the Business
When people go into business together they have obligations to one-another and to the business entity itself. The law calls these obligations fiduciary duties. They chiefly arise when someone has management responsibility over a business: for example, the members of a member-managed LLC or the directors of a corporation. This probably captures everyone involved in most small freelance partnerships. Breached fiduciary obligations tend to be a prominent part of litigation between former business partners, so it is worth knowing what your obligations are.
There are two major fiduciary duties: the duty of loyalty and the duty of care. The duty of loyalty requires the business manager to be honest while dealing with the company. The manager must put the company before her own self-interest, and must avoid conflicts of interest that could undermine the manager’s ability to make good choices for the company. The expectation is that the manager will direct new business opportunities to the company instead of taking them for herself. The duty of care requires managers to act responsibly and in good faith, taking reasonable steps to ensure that the company is well run. This doesn’t mean that the manager has an obligation to make the company succeed. The business judgment rule provides that bad decisions that cause a business loss aren’t by themselves a breach of a manager’s duty of care so long as the manager makes the decisions in good faith. A manager might run afoul of the duty of care by being sloppy or careless in operating the company, for example by signing up for expensive services that the company can’t afford and doesn’t need.
The specific obligations of a corporate shareholder or director, LLC member, or corporate officer vary somewhat by the state where the company is organized. They can also often be changed in a company’s organizing documents. For example, owners who have other business interests will probably want to document specific limits to their duty of loyalty to the partnership so they can continue to operate their side businesses without breaching their fiduciary obligations. This is an area where it can be especially useful to have an independent lawyer looking out for your interests.
Bear in mind that fiduciary duties are personal obligations. Breaching them gives the other owners of a business a cause of action to sue in court for damages. The owner who breaches a fiduciary duty might be forced to use personal assets to repay financial losses. This is an important risk to consider when thinking about going into business with someone else.
General Partnerships: The Default Rule
When two or more individuals take steps to form a business together but they haven’t yet organized a legal entity, they are deemed to be in a general partnership. Like a sole proprietorship, the partners in a general partnership bear personal liability for the obligations of the company. Any profits of the partnership are divided between the partners however they deem fit, and reported on the partners’ personal income tax returns. In a general partnership, each partner has equal power to bind the general partnership to obligations, or to dissolve it. Likewise, the partners are jointly and severally liable for the business’s debts, meaning that creditors can go after any of them to recover what is owed, regardless of who was responsible for the original debt. Then it’s up to the partner who got stiffed to go after the other partners to balance things out. If one partner has more assets than the others, that partner could end up with the most to lose.
Here’s an example of how a general partnership can fall to pieces. Freelancers A, B, and C agree to form a graphics design business. A and B are fresh out of college and have no assets other than their exceptional design skills. C, on the other hand, owns a house and has a nice investment portfolio. Although they plan to eventually organize the business in a more formal way, they let such things slip. B signs a contract for a big project that pays a refundable advance of $25,000 in anticipation that the business will need to hire a few subcontractors to make the deadline. Unfortunately, A has decided that working isn’t much fun, so he takes the $25,000 and catches a plane to Costa Rica to live for a while on the beach. Thrown into chaos, the business can’t deliver on the big contract, and the client demands the return of the $25,000. When B and C fail to pay up, the company sues, going after only C, the one with the assets. In a situation like this, C might have no choice but to sue A, since he’s stolen from B and C. But he might also need to sue B, who is just as responsible for the company’s debts as C, even though both of them are victims of their partner’s theft.
If A, B, and C had formed a limited liability entity, the story might have been different. Although the client still would sue the business, it would need additional facts to overcome the company’s limited liability protections to reach B and C personally (see Chapter 5 on how this works). The business, in turn, would have reason to go after A. But if A was gone, and the company had nothing to pay back to the client, the company, at worst, might be driven into bankruptcy. C would not be at risk of losing his house, and wouldn’t need to sue his friend B as part of the fallout.
Although there are risks to operating as a general partnership, there are several advantages that might make it an attractive alternative for new businesses. Like the sole proprietorship, a general partnership has no special formalities for its formation, so its initial administrative costs are low. A simple agreement covering the basics of the business’s operation can suffice while the business’s assets and risks are small. Such an agreement usually covers financial questions, such as how much each partner will contribute to the company and what happens if a partner doesn’t want to contribute more in the future. It might also discuss ownership of the intangible assets of the business (for example, the company’s name, logos and other trademarks, and any copyrighted works the partners might create, like website content or software code). The partners might also agree to milestones that will trigger the formation of a more formal business entity.
LLCs and Corporations
It probably comes at no surprise that LLCs and corporations are both popular choices for businesses that will be owned by more than one person. A good reason for this is that the owners don’t need to reinvent the wheel to get their company organized. Unless the owners want to do something unusual, the company’s attorney can probably prepare the governing documents without a huge extra investment over what a single owner would require. All of the principles discussed in Chapters 3 and 4 still apply to a company owned by multiple people, but there are a few extra questions that the owners will need to address at the outset. Here are a few examples:
•Management obligations and rights. Who will manage the company’s financial records? Who will take responsibility for the company’s statutory obligations, like business licenses and annual reports? Will all of the owners have formal management responsibilities (serving as corporate directors, or as an LLC’s managing members) or will some owners prefer to defer those responsibilities to working through questions like these at the beginning will avoid headaches later.
•Capital obligations. Document how a company’s owners contribute capital to the company, and their obligations to contribute more if the company needs it. Depending on state rules, contributing more money to the business might be doable without issuing more stock. It is important to properly document owner contributions to avoid misunderstandings, in part because member and shareholder contributions of capital aren’t debt. Co-owners should recognize that the company doesn’t owe them interest on the money they contribute and has no obligation to pay anything back. Owners stand to lose their entire investment if the company goes broke.
•How will the owners get paid? The company might pay the owners a salary, or it might declare distributions as the company gets paid by clients. What happens if the company is going through a dry spell? How much should the company retain in its account to pay its bills? These kinds of questions tend to get complicated and many small businesses work with accountants to help sort through them.
•Voting rights. Decide how the owners will make decisions about the company, especially about how it is managed. Allocating voting rights based on capital contributions is one way to do this, but it isn’t the only way. For example, an LLC’s operating agreement can provide that each member will have an equal say in the management of the company, regardless of how much money each member contributes to the business.
•Restrictions on sale. Most small business owners do not want their partners to be able to freely sell their interest in the company. The owners might conclude that they do not want to allow any kind of sale, or they might allow for rights of first offer or rights of first refusal, which give the nonselling partners a chance to buy out the selling owner.
•Disaster planning. The owners should agree about what happens if things go badly for the business (for example, bankruptcy), or something happens to a partner (death or incapacity). Owners of small businesses will often agree that the other owners have a right of first refusal to buy the share of the company owned by someone who dies or retires. How the company’s assets get distributed if it is wound up also needs to be covered. This is a broad category that needs the guidance of a lawyer to cover everything. Statutes that govern business entities will have a lot of default provisions covering many of these issues, but a company’s organizers are often free to depart from the default rules if desired.
The limited partnership was the first limited liability entity that offered pass-through tax treatment for its ownership. In a sense, the LLC is a refinement of the concept of the limited partnership. Quite often, their management and maintenance obligations are quite light, determined almost entirely by the documents the partners prepare when the partnership is organized.
Limited partnerships are formed by filing a declaration of partnership (or sometimes a certificate of limited partnership) with the state. The partners enter into a contract called a limited partnership agreement, which sets out how the company will be managed. These documents can be remarkably simple for a simple business structure, though the limited partnership agreement can get more complicated if the partners want to organize their management or financial obligations in a way that departs from the statutory defaults.
Limited partnerships have two types of partner: limited and general. Like corporate shareholders, limited partners do not take part in the management of the company. In turn, they do not have personal liability for the debts and obligations of the company. The general partner, on the other hand, manages the company and does bear liability for its obligations. A general partner usually cannot be a limited partner, and in some jurisdictions such an arrangement can cause the partnership to immediately dissolve, essentially reducing it to a general partnership. The general partner acts as the limited partnership’s agent and handles all of the company’s day-to-day operations, from running bank accounts to signing contracts.
A general partner can be a natural person, or it can be a legal entity. Sophisticated businesses that use limited partnerships as part of their tax structuring strategy will often form special purpose entities, such as an LLC, to serve as the general partner and shield “upstream” owners from liability for the partnership. Technically, an individual freelancer could form a single-member LLC to serve as general partner in a limited partnership, with the freelancer holding the limited partner interest. Although there is nothing stopping a freelancer from doing this, it is unlikely to offer any advantages over just using an LLC or corporation for the business.