As an entrepreneur, you probably have a big idea and the self-confidence to dive in and make it work. But it’s important not to be blinded by your vision and ignore the importance of the legalities of starting a business. You may have a DIY attitude, and that’s great. But this may not be the place to use it.
You need to protect the lifeblood of your business before you make yourself – and your business – vulnerable to the legal woes of client-business relationships.
If you’re not the sole founder bootstrapping your venture, you’ll need to set up an operating agreement to govern sticky situations you might encounter. Just because you can get fill-in-the-blank legal documents from Google, that doesn’t mean you should. It’s best to have legal counsel to guide you through the operating agreement. Otherwise, you could sign away control of your business further down the road.
Whether you have legal counsel or not, it’s still advisable for you to understand certain terms found in operating agreements, contracts, and other business documents to make the transition smoother.
1. Capital account
This business account shows the net worth of a company based on the interest in the assets of each owner or shareholder. Basically, it tracks the contributions, distributive shares, cash draws, and taxable losses of a business partnership. If, for example, your business partnership defaults on a debt or dissolves the enterprise, the capital account balances would tie back to equity ramifications, taxation consequences, and almost anything in your business’s operating account for each partner. It’s important to know how the capital account balances affect your business partnership.
2. Restraint on alienation
Restraint on alienation limits the ability of owners to sell or transfer shares of the company and similar transactions. So pay special attention to your ability – as well as the abilities of any co-founders or investors – to make ownership changes to your company.
3. Mandatory contribution
A mandatory contribution is a required contribution employers must make in alignment with corporate governance documents. Many times, investors require shareholders to contribute to capital calls. If anyone fails to do this, it could dilute your ownership.
4. Dilution of equity
Dilution of equity refers to a decline in your stock’s value, which commonly occurs when new stock is issued. When other stockholders or holders of optionable securities exercise their options, it can also affect the value of your stock. For example, let’s say you offer stock options to your employees. As more shares are created and issued, the value of each one diminishes.
5. Fair market value
Fair market value is the value of property when it’s sold in a voluntary transaction. When entering into a partnership or business, you generally set an agreed-upon FMV of company-owned assets, with the ability to adjust the FMV of each item from time to time. Be careful about tying the terms of your corporate documents to FMV because hiring business valuation experts can be incredibly expensive. Often, more than one expert will be involved and will vary on the FMV, making it difficult to settle any corporate events.
Dissolution occurs when a company distributes its assets and no longer exists. Many entrepreneurs gloss over this section of an agreement because they figure that the business would have already failed. But this is a costly mistake. This section can include clauses that force an otherwise equal partner to exit, which is problematic if your company becomes wildly successful. Sometimes it includes clauses that permit boards to vote whether to dissolve a company. Go over this section closely or a partner could gain the power to oust you from the company you built.
7. Board versus management powers
In most cases, corporate governance documents address management powers and board member powers separately. Make sure you either control the board or have the necessary powers with the right individuals. Mark Zuckerberg, for example, owns just 28.2 percent of Facebook’s shares, but a voting arrangement in the SEC filing makes a certain number of shares subject to voting proxy, giving him 56.9 percent of the vote. The best way to protect yourself is to read the documents under the assumption that your co-founders will vote against you on every board vote.
8. Majority and supermajority
In voting, majority means more than half, while supermajority means much more than half, typically ranging from 67 to 90 percent. In any provisions in your business documents, make sure to note the definition of supermajority because it can vary. For example, if a certain action requires a supermajority to pass, you need to know how many votes it would take to reach that number. Let’s say a supermajority is set at 85 percent. For a board of five, you’d need all five votes to reach a supermajority. On the other hand, a supermajority of 75 percent would only require four votes.
If entrepreneurs weren’t risk-takers, they wouldn’t be entrepreneurs in the first place. But the worst mistake you can make is failing to realize when a situation presents more risk than potential savings in legal costs.
While you might be hesitant to hire a lawyer initially, you can’t afford to open up shop without the backing of an experienced professional. Most business lawyers offer a free consultation. Take advantage of it, or consult mentors to determine which documents or situations require legal counsel. When you can rest easy knowing that your legal bases are covered, you can concentrate on providing the best product and experience possible.