This post will help you think through six of the most basic questions that you’ve got to answer before starting a business with friends.
Let’s talk about some of the pitfalls of starting a business with friends. We see this all the time at Dunlap Law. We frequently get clients who four or five years ago went into business with a friend or a couple of friends. At the time they thought they’d save some money and not hire an attorney. That was a big mistake and it ended up costing them far more several years later to try to unwind the problems that were created because they didn’t get it right from the start.
Starting a Business With Friends
Let’s start with the beginning of a business venture. It’s a really exciting time; you and your friend(s) have a great idea and you’re sure it’s going to work. One of you has some capital and the other has some experience and you’re going to start a business together. You’re going to build something that’s yours, something that matters.
This is a time of great optimism and that’s wonderful! It should be. If we weren’t hopeful, nobody would ever start a business because it’s hard and it’s scary. You’ve got to be hopeful. That’s reasonable, but you should recognize the way human nature works. When we are optimistic about a new venture like this it also makes us blind. It makes us blind to the pitfalls, blind to our own shortcomings, our friends’ shortcomings, and blind to the critical importance of getting the right deal in place at the start.
That’s what a good attorney is for.
How Does a Business Attorney Help?
Many people don’t really understand the role of a business attorney, so let’s talk about that briefly. My job is to help you see your blind spots. My job is to help you understand some of the problems that could arise in the future and put measures in place right now in a carefully drafted document that will prevent misunderstandings and problems in the future. Many people think that a lawyer’s job is just to draft some documents and that’s really not the case. One of the words for a lawyer is “counsel”. We provide advice.
It’s critically important that you have a good advisor at the beginning of a business venture.
Every business will have governing documents that dictate how the business partners operate with one another, how they treat one another, how new partners might join, etc. All of these are big questions to answer. It’s important to get those governing documents right at the beginning. If you don’t get them right at the beginning, then it’s almost certain that misunderstandings are going to arise and you will need a lawyer years down the road to unwind some of the problems that arose because the governing documents don’t help you govern.
This post will help you think through six of the most basic questions that you’ve got to answer before you start your business.
1. What Will Each Person Contribute to the Business?
I have tons of clients come to me after starting a business with friends. Usually, one of them contributed money and the other one is supposed to contribute sweat equity, industry knowledge, marketing services, or some other in-kind contribution.
Inevitably over time, the person who was supposed to contribute the services gets distracted or maybe they have other interests that are capturing their attention. Regardless, for whatever reason, they’re no longer contributing as many services and as much time as you think they should. Then, the person who put the money in is looking at the person who’s supposed to put in services thinking, “Hey, aren’t you supposed to be doing x, y, and z?”
You’ve got to think carefully if you’re contributing different talents or amounts of capital. You’ve got to be really careful in how that’s structured and accounted for.
We have plenty of experience in putting together deals like this, so we’ve got ideas that can help you. You’ve got to have a plan for addressing this question when you’re starting a business with friends.
2. Will Your Rights In Your Business Be Proportional to the Contribution to the Business?
For instance, if one person is putting in $100 and another person is putting in $100, that’s really simple you’re each 50/50. Well, it’s almost never that clean when people are starting a business. Typically, one person has more capital assets than another, so they’re willing to put in more capital and the other person is contributing services, equipment, or inventory. Often, these things are mismatched, so how are you going to handle that?
Is the person putting in capital going to have more say in the running of the business? This is an important consideration even when you’re starting a business with friends. We can help you adjust for that in your governing documents.
3. What If One of You Wants to Resign?
It’s not fun to think about when you’re starting a business with friends, but what if one of you wants out of the partnership after a couple of years? Do you want to allow this, or not? If you don’t put this in your governing documents, then under Virginia law it might be extremely difficult for the person who wants to leave an LLC (see more about this in our LLC series). In fact, you might be trapped unless you go to court, so it’s important to think through whether or not a member can resign from the LLC.
If they can resign, what are the terms of that resignation? The members who are staying in the LLC don’t want to be caught short because somebody wants to leave. This has to be carefully structured and we have lots of experience with this, so we can help you figure out what that structure should look like.
4. Whether or Not You Need a Prohibition Against Engaging in Competing Business Activities.
Think about it, you start a business with friends, and three or four or five years down the line one of your friends is distracted and they’re no longer working on the business that you’ve started together. In fact, they’ve started a side hustle that’s competitive to the core business that you started together. Should you have terms in your governing documents that prevent this from happening?
That’s a really tricky question and we can help you think through that as you get ready to launch your business.
5. Who Will Manage the LLC?
You have to decide whether or not your LLC will be managed by all of the members or if you’re going to designate one person. Who will manage the LLC?
Now a manager could also be a member of the LLC, but not necessarily. Sometimes LLCs hire an outside person who’s not a member to act as the manager. If that’s the case, then you want to think carefully about the scope of responsibilities and the scope of authority that that manager has.
If you’re not going to have a manager, then you need to think carefully about the scope of authority that each member has. Will members be able to sign a contract on behalf of the LLC and bind that LLC without talking to other members? That could be dangerous, but if you put in terms that are too restrictive, it could prevent the LLC from effectively governing.
Again, this is a tricky balance and we can help you strike that balance.
6. Can a New Member Join the LLC?
If so, what are the terms? Will the existing members be able to have a majority vote on a new member joining or should it be unanimous? If a new member is joining, what kind of contribution should they be required to make as they join? How will the membership interests of the existing owners be handled? Will they be evenly distributed or will their ownership interest be distributed a little bit differently depending on their contributions?
All of these are tricky questions. These are issues that you need to think carefully about as you take steps toward starting a business with friends.
As small business attorneys, we specialize in helping you solve these questions, develop an operating agreement or articles of incorporation, and bylaws that will really help you get off on the right foot with your new business.
These governing documents are essential to your future success and hold the power to make or break your business.