Business Litigation Alert: "Starting a New Business? Include These Five Provisions in Every Formation Agreement"

The ultimate success of a business often rests on the ability of its owners to make sound decisions up front - an ounce of prevention, if you will - and avoid bigger problems that might arise later.  This principle particularly applies to the written agreements used to form and start the business.  Specifically, the business should have a well thought out and robust formation agreement that anticipates and addresses likely areas of conflict that typically arise between business owners.  Sharing lessons from past disputes, here are five provisions that every business formation agreement should address.

  1. Choice of Law:  States have different laws regarding the formation and operation of limited partnerships, LLCs, and corporations.  Deciding which state law will govern the business provides the substantive rules and framework for resolving disagreements about matters that are addressed (and not addressed) in the agreement.
  2. Ownership / Economic Deal:  If the company is a partnership, there can be no partnership unless there is an agreement to share profits or losses.  So, this is a threshold matter for partnerships.  It also is fundamental for any other form of company.  In the absence of addressing this, there really is no deal.
  3. Control / Management:  There must be some structure around how to make decisions affecting the company.  One of the most important elements relates to day-to-day activities – who is going to operate the business?  Decision-making around major events (buying/selling assets, taking on debt or fresh equity, expanding or shrinking operations, etc.) also is important to address.
  4. Transfer Restrictions:  In most instances, there should be some limitation on the ability to transfer ownership interests in a company (assuming a private company).  The owners should also consider limitations on certain buy-out rights or obligations that arise in the event of death, divorce, and/or termination of employment, as well as the occurrence of certain “events of default”, such as breaching the agreement or becoming insolvent.  The idea is to allow co-owners to preserve the benefit of their bargains to be co-owners with each other and not with unknown third parties who could become co-owners in the absence of such restrictions.
  5. Exit Strategy:  It is important to include some type of exit strategy to provide a path for co-owners who no longer want to be in business together to try and separate themselves from each other without having to dissolve the business.  This could be in the form of “push-pull”, drag-along, and/or “forced sale” and other similar rights.

This list is, of course, not exhaustive, but these five provisions should be adequately addressed in most business agreements.  Remember, failure to plan can lead to costly and lengthy legal battles down the road.

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