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A Guide to Your Limited Liability Company Or Partnership Documentation

If a question comes up, where in you partnership or LLC documentation do you look first for answer?

One of the great advantages of these non-incorporated business entities is the huge amount of flexibility they allow partners to structure ownership and control. However, with flexibility comes complex documents. While state law can fill in some of the gaps , the fact that many partners want a different arrangement can add many pages. Nonetheless, since a handful of issues come up most often, standard documents have evolved. Please note that this Guide uses the terms “partners" and “members" interchangeably.

Certificate of Formation

General partnerships are formed when two or more people or entities decide to go into business together under one roof. Partners do not have to file anything with the state to create them (please note that local business permitting is beyond the scope of this guide). They are easy to establish, but they have downsides:each partner has unlimited personal liability for company debts; each can legally bind the company; and unless there is a written agreement all profits and losses are shared equally. Limited liability companies and limited partnerships are different. They avoid some of the concerns with general partnerships but need to be formed at the state level first. Under most state laws, partners can accomplish this through filing a short document called a Certificate of Formation or Articles of Formation with the state. It basically sets forth the name of the entity, although in some states the names of the initial members and managers also need to be included.

Partnership or Limited Liability Company Operating Agreement

The partnership agreement or limited liability company operating agreement is the core document governing the rights and responsibilities of members. They look slightly different depending on the form of organization but contain many similar provisions. In a general partnership, each of the partners has full authority to bind the business and make business decisions. In a limited partnership, only the general partner has these rights; the limited partners may have the right to vote on a limited range of matters, but are otherwise silent. In a limited liability company, the members have a great deal of flexibility as to which members have which rights and obligations. In addition, limited liability company statutes explicitly provide for "managers" who, like corporate officers, have decision-making and operating authority whether or not they are owners.

Most agreements contain some of the same basic elements:

  • They describe the name, purpose and term of the entity's existence.
  • They describe the process for admitting additional members.
  • They describe capital contributions made by the members and the procedure for calling for additional contributions. They should also describe percentage ownership and percentage vote for control purposes, which may or may not be the same and may or may not relate to capital contributions.In particular, partners that contribute cash, property and services may be treated differently; there may be a concept of “preferred return," like preferred stock, in which some partners get cash out first; partners may get different returns on different streams of income; and there may even be complex “waterfall" structures in which one group of partners gets a larger split of first income, then another group gets a larger split of income after a threshold is met, then yet another group gets a larger split after another threshold is met.
  • They describe the timing and amount of distributions, including any required minimum distributions. Since these entities are considered pass-through entities for federal income tax purposes (so that company gains and losses are taxed directly to the partners), the governing documents should describe how gains and losses are allocated among the partners. The allocation provisions may be straightforward or very complex, depending on the entity. Partners generally do not want phantom income (income that is allocated to them but not matched by at least enough cash distributions to pay tax on it). In the past, so-called “tax shelter" partnerships were common; these partnerships generated phantom losses against which partners could deduct their other income. This is much more difficult to accomplish under today’s tax code.
  • They describe management and control. Depending on the type of entity, it can be set up to look like a traditional general partnership, with each member having the right and authority to bind the entity on all matters, or fall anywhere within a range of more restrictive options up to and including an organizational form that looks like a corporation, with a Board of Directors and officers who may or may not be members. If the documents are drawn up well, the draftsman may have averted partner deadlock issues. Sometimes, though, the resolution of those issues may be thrown back to whatever state law provides in the case of deadlock.
  • They describe restrictions on transfer. Typically, people do not want to be forced into partnership with people with whom they have not agreed to be partners. Most partnership and limited liability company agreements contain restrictions on transfer of ownership interests, and restrictions on any transferees' becoming full-fledged members without the consent of the other members or a governing body of the entity. Restrictions on transfer also include rights of first offer or refusal in most cases, as well as the right to participate in a sale by partners with a larger interest (“tag-along rights") and, for partners with a larger interest, the ability to cause smaller partners to participate in a sale of a significant portion of the company (“drag-along rights").
  • They describe what happens on death, disability, divorce or retirement of individual partners, and address what happens if a partner becomes bankrupt or insolvent.

  • Although all state statutes have a procedure for dissolution, they expand on the statutory regime.

  • If the entity will be operated by individuals, agreements often contain indemnification obligations or even employment-type provisions such as noncompete agreements.

Annual Report

In many states, the annual report filed with the state lists of some or all the partners and, in the case of a limited liability company, managers. If you are facing an issue of ownership or control, you might look here for further information. Also, if the report is not filed on time, the company is not in “good standing" or might even be administratively dissolved, which leads to all sorts of problems.

Federal income tax returns can have valuable information, too. For instance, the Schedule K-1s indicate percentage ownership.

Warrants and Options

Warrants and options give the holder the right to acquire an interest in a company in the future at a specified price. The holder hopes the price is below market value at the time of exercise in order to make a profit on the difference between the exercise or "strike" price and the market value. Warrants are often granted as part of a company financing. Options are often granted to employees, sometimes as part of an employee stock option plan.Because they create tax complexities, warrants and options are not as common in partnerships and limited liability companies as they are corporations.

Registration Rights Agreement

Registration rights agreements entitle a business owner to participate in public offerings by the company or certain other owners ("piggyback registration rights") or may even require the company to conduct a public offering ("demand registration rights").These agreements provide for “cut-backs" if the underwriter thinks too large an interest in the company is being taken to market at the same time. If a company goes public without registering all its shares in the transaction, a partner may still be able to sell – but the intricacies of securities law are beyond the scope of this Guide.

As with warrants and options, registration rights are not as common in unincorporated businesses as they are in corporations. Many companies do not bother to draw up a registration rights agreement until an outside financing source demands it, and for various reasons many institutional investors prefer to invest in corporations.

Employment and Independent Contractor Agreements

Often, the management provisions of a partnership agreement or limited liability company operating agreement are all that is needed to describe the rights and responsibilities of those managing the business. However, especially if there are officers or employees who are not owners, those who work with the company may have employment agreements that spell out job titles, responsibilities, compensation and benefits, grounds for termination, severance and related issues. The agreements often also have confidentiality, intellectual property, noncompete and indemnification provisions. Independent contractors can have similar agreements and outside managers of a limited liability company often have written indemnification agreements in addition to their compensation arrangements. These types of agreement are the baseline against which all discussions with individuals are negotiated.

Debt Arrangements

Debt arrangements come in many forms, ranging from simple promissory notes to loan agreements and, in larger companies, bonds or debentures. Furthermore, many companies have multiple debt instruments outstanding at any time. The voluminous, complex documentation of debt is beyond the scope of this Guide, but as an owner you should look closely for collateral security documents such as personal guarantees and pledges of your ownership interest.

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