New Business Formation - Planning for the Future from the Beginning

May 29, 2018

By: Barry Dorans

In an earlier article, I discussed the importance of selecting the correct business entity. In this article, I will discuss some of the issues that arise regardless of the type of entity you chose.

When one individual wants to form a business, it is not that hard to have the paperwork completed. When there is more than one owner, however, other issues arise. For example, how are profits to be split? It is not uncommon to hear that the parties agree that Sue is to get 60% of the profits and Bill is to get 40%. Have they considered, however, that profits are paid after all of the expenses, including salary or other compensation to the employees? If Sue also provides services to the company and is paid a salary, do we count that in determining the 60%? Note that if Sue has a 60% vote, can she give herself a raise to increase her salary so that there are no profits paid to Bill? These are important issues that need to be ironed out at the outset of the formation of the company.

Second, in terms of decision making, are all decisions made by simple majority vote or are there some decisions that require the agreement of all the owners? Can the majority owner approve the sale of the company’s real estate, borrow money from a bank and/or hire their family member? Will there be restrictions in the agreement that require more than a majority vote to approve those actions? Again, these are items that need to be discussed by the parties at the outset.

Third, do the owners want to have a provision that requires an owner to sell their interest if they no longer work for the company? What if Bill owns 40% of the company, but decides after six months he no longer wants to work there and leaves, does Sue have any ability to force Bill to sell his ownership back? What if Bill goes to work for a competitor, does Sue still have to pay Bill 40% of any of the profits earned by the company?

Similar issues arise upon death or disability. What if Bill dies, does that mean Sue is now in business with Bill’s widow? These issues can be addressed with a Buy-Sell Agreement which is best negotiated when the company is formed.

For each of these reasons, it is very helpful for an individual thinking of starting of business to hire a lawyer to give them advice on how to best protect their interest. It is much easier to reach agreement on these issues at the start of a business, since the owners do not know whether they will be selling their interest or the one acquiring the interest. Once an event has happened, such as the death of an owner, or the owner’s decision to stop working, the owners may have dramatically different views of what is fair.