You may have had a conversation with a friend about how you would do well as business partners. Or perhaps an industry contact suggests participating in a startup. Sharing ownership of a business with another person can have significant benefits, including a larger pool of human and financial capital. Of course, shared ownership also has the risks of tying your financial interests to another person.
Before expending significant time and money, your potential business partner and you should document the terms of your relationship. Courts generally will enforce oral agreements except where a state’s law requires that a particular agreement be in writing. For example, contracts for the sale of real estate and contracts for long-term loans must be in writing to be enforced by most state’s courts. Independent of legal enforceability requirements, however, putting a business agreement in writing is a very practical measure.
Even if each partner believes that the other will adhere to the terms of an oral agreement, a written agreement has the value of fixing the partners’ collective memories as of a point in time. Years from now, the two of you may not remember the agreement exactly the same way. Misunderstandings between owners can destroy an otherwise successful business; a written agreement at the beginning will minimize misunderstandings in the future.
The written agreement should cover topics including the partners’ individual contributions to the business, the procedure for a partner to exit the business, and details on how the partners will share operational activities of the business.
The specific types of the written agreements that co-owners should enter varies depending on whether the business is organized as a general partnership or as a business entity registered with a state government, such as a corporation or limited liability company. The following details the types of written documents required for each type of entity.
How Formed: two or more businesses contract with each other to cooperate on a particular business goal
Document Name: Joint Venture Agreement
Legal Requirement: no
Practical Measure: yes (helps ensure that the goals of each venturer are enforceable and avoid treatment as a general partnership)
A joint venture is any limited-purpose business venture between one or more business partners. It is not its own type of business entity. Joint ventures may be general partnerships, corporations, limited liability companies, or any other type of business entity, or they may simply be contractual relationships.
The contract between business partners to form a joint venture can be legally binding even if it is not in writing. However, for the reasons described above, a written Joint Venture Agreement is strongly preferable. The content of the Joint Venture Agreement will vary depending on the type of business entity the joint venture assumes; look to the type of entity below to see the details for that type of agreement.
How Formed: by default, if two or more people go into business together but do not register a business entity with the state
Document Name: Partnership Agreement
Legal Requirement: no
Practical Measure: yes (though even better to organize as LLC and add limits to liability)
A general partnership is any group of two or more persons who carry on a business with the goal of making a profit. As soon as the partners begin carrying out the business, they have a general partnership—no filing with the state is required. Indeed, the partners may have a general partnership without even realizing it.
The greatest risk of a general partnership is that each partner is personally liable for all of the partnership’s debts and obligations. For this reason, most business owners choose to form a corporation, limited liability company, or other business entity registered with the state that protects the owners’ personal assets from the business’ liabilities.
For partners who do want a general partnership, a written Partnership Agreement is preferable over an oral agreement. A court will enforce an oral partnership agreement, however.
How Formed: file Articles/Certificate of Incorporation with the state
Bylaws and Resolutions (for internal operating rules of corporation)
Stockholders’ Agreement (for rules regarding sale/transfer of stock by shareholders)
Legal Requirement: yes (Bylaws and Actions of Stockholders and Directors)
Practical Measure: usually – if more than one stockholder, a Stockholders’ Agreement is also advisable
A corporation is formed by filing incorporation paperwork with a state government. A corporation may have only one owner, a few owners or many owners. The owners, known as shareholders or stockholders, elect a Board of Directors, and the Board of Directors in turn appoints officers of the corporation who manage the business’s day-to-day operations.
In general, a corporation must have a basic set of written documents no matter its number of stockholders. The Articles or Certificate of Incorporation filed with the state are one required document. The corporation must also have Bylaws—rules for the internal operation of the corporation—and written documentation of the actions taken on behalf of the corporation by its stockholders and directors.
In closely-held corporations (i.e., those with two to about 25 stockholders), the stockholders may have particular expectations regarding the ability of sell their stock in the corporation and/or to vote for particular persons to be on the corporation’s Board of Directors. The stockholders should document their agreement on those issues in a Stockholders Agreement.
How Formed: file Articles/Certificate of Organization with the state
Document Name: Operating Agreement (addresses both the internal operating rules and the rules regarding sale/transfer of membership interests by the members)
Legal Requirement: maybe (required in some states, including the District of Columbia; not required in others, including Virginia, Maryland, Delaware)
Practical Measure: yes, regardless of the number of members
Like a corporation, a limited liability company is formed by filing organizational paperwork with a state government and may have any number of owners. The owners of an LLC are known as members. Unlike a corporation, most state’s laws allow LLCs to have very flexible internal operating rules.
The members of an LLC set those internal operating rules in an Operating Agreement.* The same Operating Agreement also reflects the members’ decisions on rules regarding the transfer of their membership interests.
The law on whether an Operating Agreement must be in writing is surprisingly complex. Members of an LLC may eliminate all doubt by adopting a written Operating Agreement. If they rely on an oral Operating Agreement, a court may not enforce all of the terms. The laws of a few jurisdictions, including New York and the District of Columbia, specify that an Operating Agreement must be in writing. The laws of others specify that an oral operating agreement is enforceable only for certain issues. Further, general state law on the enforceability of oral agreements adds a layer of uncertainty to the enforceability of written operating agreements that require members to make particular types of capital contributions to the LLC. For all of these reasons, in addition to the reasons identified in the introduction to this article, every LLC should have a written operating agreement.
* Because the Operating Agreement lays out the internal operating rules of the LLC and documents the identity of each member of the LLC, even single-owner LLCs have an Operating Agreement.
Every business owner should document his or her agreement with the co-owners of the business. Some of the reasons are purely legal: a state statute requires a written agreement. Others are more practical: when a dispute arises, better to have a document that recorded the partners’ understanding at a point in time than trust a judge to correctly divine that understanding years later. Regardless of the motivation, a written agreement helps set a solid foundation for a successful business.