Feb 10

Why A Handshake Agreement Among Business Partners Is Not Worth The Paper It Is Written On

shutterstock_325478696You go into business with your sister, your father, your college roommate or your best friend.  The classic “we-started-in-the-garage” business. You struggle at the beginning – you do whatever you can to minimize overhead.  Lawyers are expensive so you decide not to put anything in writing – any arrangements with your partner are based on your long-standing personal relationship, not on high-priced technical legal documents that no one reads anyway.  After a few years the business turns around and you are making money.  You move out of the garage to an office, add some employees, go on increasingly nice vacations each year.  Everyone is getting along and the business is doing well, even great – you have achieved your dream of independence, no boss to answer to, doing what you want and making money. And all with a handshake and a long-standing healthy relationship with your partner.

This sounds like a nice story and it is – and all without the involvement of lawyers.  What could be better?  What could go wrong?

Unfortunately, lots of things could go wrong.  Written business documents like partnership agreements, operating agreements, buy-sell agreement and bylaws may seem unnecessary when a business is getting off the ground and you may never read them once they have been prepared, signed and stored (somewhere).  But they are important. They provide direction and guidance when circumstances change, when the business is not doing well or when the business is doing so well that you want to expand, add partners or sell.

Here is a list of some of the reasons that documenting your business relationship is worth, at least, the paper it is written on and likely lots more:

  1. Creditor Protection. A primary benefit of entities such as corporations, limited liability companies (LLCs) and limited liability partnerships (LLPs) is that the owners of the entity are not liable for the obligations of the entity.  A creditor seeking to attack this creditor protection benefit may attempt to “pierce the corporate veil” by arguing that the corporation, LLC or LLP does not exist separate from its owners and is therefore a sham.  Having paperwork in order helps defeat this argument.
  1. Tax Status. The tax status of an entity (i.e. partnership, S corporation, C corporation, proprietorship) can be established and supported by proper documentation.
  1. Ease of Transfer of Business Interests. If a business owner is contemplating transferring business interests to family members or to trusts for their benefit as part of a business succession plan or estate plan – that can only be achieved if the entity’s paperwork accurately reflects who the owners of the business are.
  1. Addressing Changed Circumstances of a Business Owner. The divorce, disability, bankruptcy or death of one business owner can affect the interests of the other owners and the operation of the business.  For example, if a married owner is divorced or dies, without an agreement among the business owners, the widow(er) or former spouse may not only become a partner or shareholder in the business but may also have a vote in operating the business.  Also, one owner may attempt to sell or otherwise transfer an interest in the business to a new owner without the approval of the other owners.  What are typically called “buy-sell provisions” contained in a written agreement among the owners, can address these changes of circumstances so that the other partners are not in business with a new and perhaps unknown (or known but disliked) partner.
  1. Governance. If there is no paperwork describing how decisions about the operation and direction of the business entity are to be made, the law of the state in which the business operates will dictate these “governance” issues.  The business owners should come to an agreement about how decisions are to be made and document them in bylaws, a partnership agreement or an operating agreement.
  1. Sale of Business. The sale of a business which has been properly documented is significantly easier to accomplish than the sale of a business without appropriate paperwork.  Incomplete or improper paperwork can make the sale of a business far more cumbersome, and can result in a lower purchase price.  In extreme cases, it could make the sale of the business impracticable.
  1. State Law. Laws applicable to the operation of a business can vary greatly by state.  Some states have laws which are more favorable to the operation and governance of a business than others.  The choice of which state law applies can be made in an agreement among the owners of the business.

If you are a partner, shareholder, member or owner of a business without paperwork or with paperwork which is outdated, you should have your situation reviewed by counsel.  It could sustain and enhance the story of your successes.

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