The Importance of Understanding Bylaws and Operating Agreements
by Peter Smith
One of the most common questions coming from start up companies revolves around what corporate governance documents are needed upon formation. Whether you are incorporating as a limited liability company (an “LLC”) or a Corporation, you need to take the time to put together and understand the initial corporate governance for your company, to ensure that you are adequately protected and in compliance with the relevant state laws.
There are 2 main documents that are important for LLCs and Corporations upon formation. The first is the charter document, either the articles of incorporation (for a corporation) or the certificate of formation (for an LLC). The second important document is the internal governance document for the company, either the bylaws (for corporations) or the operating agreement (for LLCs), which lay out the basic operating procedures for the company.
No matter what kind of entity you are forming you will have to create and file some type of charter document. Called the articles of incorporation for a corporation or the certificate of formation (or certificate of incorporation in some states) for an LLC, this document is the initial filing, generally with the secretary of state’s office in the state you have formed, that forms a company upon acceptance by the government. Depending on your state of formation, the charter document may be filled out and filed online. If not, you should carefully research the charter document requirements in your chosen state of incorporation before filing because if the requirements are not met then the charter document will be rejected.
After filing your charter document, the next step is to create and execute the internal document that governs how your company will run. These documents are “internal” because they are not filed with the state; therefore, unlike the charter documents, these documents are not publicly accessible (unless the company makes them public). For LLCs that document is your operating agreement. For Corporations, Social Purpose Corporations, Benefit Corporations, and Nonprofit Corporations, that document is your bylaws.
The LLC Operating Agreement
The operating agreement of an LLC is the contract entered into between all of the members (aka owners) of the LLC. LLC members are generally given wide latitude to determine how they want their company to be run. An LLC operating agreement can be as simple or as complex as you want it to be. It can be a framework for how the company should be governed – setting forth the initial member contributions (either cash or in-kind), management responsibilities, accounting principles, and other core understandings as to how the company should function. In the alternative it can also be a very complex document, detailing how member’s capital accounts will be treated, how the LLC tax returns will be prepared (and who is responsible for that), and what restrictions are in place regarding the purchase or sale of membership interests (i.e. rights of first refusal).
One of the core tenants with an LLC operating agreement is its flexibility. While there are obvious contract restrictions (i.e. an operating agreement cannot contract for something illegal), for the most part LLC members are given the freedom to determine how they want their company to be run, and can memorialize that in the company’s operating Agreement.
Something important to remember about an operating agreement is that it is a contract between the members, and the members are bound to the terms of that contract. The provisions of an operating agreement are enforceable in a court of law.
Similar to an operating agreement for an LLC, the bylaws of a Corporation determine how the Board of Directors will govern a company. Generally there are statutory requirements for what information must be contained in bylaws, such as the minimum and maximum number of directors at any one time, or how shareholder meetings and special meetings may be called (in Washington State, for example, RCW 23B.02.060 sets forth bylaw requirements), but in addition to those provisions required by statute, a corporation may include numerous other guidelines for the governance of the company. Again – based on the complexity of the business, or whether or not the corporation anticipates having numerous shareholders, the bylaws can either be fairly straightforward, or extremely complex.
The bylaws are executed by the original Board of Directors, and can be amended or modified if a sufficient percentage of directors or, in some cases, shareholders, vote in favor of the change.
An important distinction between a corporation’s bylaws and an LLC operating agreement is that the Board of Directors of a Corporation are not parties to the bylaws. The bylaws govern the Corporation, but the individual Board of Director members are not named parties of interest in the bylaws.
The Importance of Understanding Your Governance Documents
One of the most common mistakes we see is the do-it-yourself operating agreements and bylaws. What is making the do-it-yourself mistakes more common is the advent of online templates that can either be downloaded for free or purchased from companies such as LegalZoom. These companies advertise legal documents in a “one size fits all” model, but the reality is that most companies are not the same because the owners and management have different expectations of their roles and responsibilities.
The problem with these documents is that they are rarely comprehensive and, often times, the individuals that procure these documents do not read them carefully or understand them before signing them and moving on. It is confounding to see a fledgling company with great energy and a solid business plan, but also with owners who do not have a full understanding of how their own company should operate. It’s one of those things that largely go unnoticed until there is a company dispute or one member/shareholder wants to disassociate. Only then, when something goes wrong, are these documents pulled out and examined to determine how the dispute resolution process will work. Frequently there is no procedure (and if there is any guidance it’s just a standard jurisdiction and venue clause directing you to the courts) and the method of untangling the adverse parties becomes burdensome and costly to everyone involved. Many companies that do not hire legal counsel to help put these initial documents together, wind up hiring lawyers later on to help litigate the disputes that arise from inadequacies and inconsistencies in these documents. Hiring counsel to draft these documents is much less expensive than protracted civil litigation.
A lot of grief and unnecessary legal hassle can be avoided by taking the time to tailor and understand your operating agreement or bylaws from the outset. For instance, what happens in the case of a deadlocked vote? What if a majority owner becomes incapacitated or, heaven forbid, is killed? If they’re married, will their spouse inherit the interest in the LLC or Corporation? Do you want to be in partnership with someone’s spouse? All these questions, and more, can be answered through operating agreements and bylaws.
When you are getting started, and reviewing your initial operating agreement or bylaws, ensure that they make sense for your company and that the processes and procedures set forth in these documents are clear and concise. Make sure that important issues such as indemnification and the scope of management authority are laid out. Finally – make sure that every founder, member, or individual on the board of directors has taken the time to read and understand these documents as well. Doing so will allow everyone in the company to better understand the structure of your business, and create a more conducive environment for launching your business on the path to profitability.
The article provided above is for general information purposes only and should not be relied on as specific legal advice. This article does not form an attorney-client relationship. If you have any questions about this article, please feel free to contact Eric Camm at Eric@apexlg.com
June 29, 2020