When is It Okay to Ignore Owner Contracts, Bylaws, and Articles?

As a business owner, your primary objectives include maintaining control of your company, preserving your rights to its profits, and keeping your ownership intact. However, these goals are not always straightforward to achieve.

The Importance of Written Agreements

Consider the case of a business owner who partnered with a best friend. They agreed that the friend could earn more ownership by meeting certain conditions. However, these conditions were never documented. Over time, the friend, who managed the finances, began taking more profits and making decisions independently, claiming he had met the conditions to increase his ownership stake.

Without written agreement documentation, the original owner found his ownership percentage reduced significantly, leading to a prolonged and costly legal battle. This story underscores the critical need for clear, written agreements that define ownership, control, voting rights, and profit distribution.

Key Legal Documents

  1. Articles of Incorporation/Organization: These documents are filed with the state and are necessary for forming a corporation (Articles of Incorporation) or an LLC (Articles of Organization). They are generally concise and serve as the foundational public document for your business.
  2. Bylaws/Operating Agreement: For corporations, internal rules are laid out in the bylaws. For LLCs, these rules are typically found in the operating agreement. These documents detail the internal mechanics of the business, including officer roles, voting procedures, and profit distributions.
  3. Additional Owner Agreements: Beyond the primary documents, owners can enter into other agreements such as shareholder agreements, buy-sell agreements, or member agreements. These agreements are usually binding on the signing parties and sometimes on future owners.

Hierarchy of Authority

The hierarchy of authority in a business structure typically follows this order:

  1. State Statutes: These are the highest authority governing business operations.
  2. Articles of Incorporation/Organization: Filed with the state, these define the basic structure of the business.
  3. Bylaws/Operating Agreement: These documents outline the internal rules and procedures.
  4. Additional Contracts: Any other agreements signed by the owners fall below the bylaws or operating agreement in terms of authority.

Confidentiality and Disclosure

While the articles of incorporation or organization are public documents, bylaws, operating agreements, and other owner agreements are usually not publicly filed. They might be disclosed to banks for loans or to other entities that request them, but they remain generally confidential.

Preventing Disputes

To avoid misunderstandings and expensive legal disputes, ensure all agreements are documented in writing. Clear, written agreements help prevent frustration and legal battles, which are often the result of perceived betrayals between business partners. A crucial part of this documentation is the buy-sell agreement, which outlines the process for a business owner to exit the company. This agreement should cover how to value the existing owner’s shares and the options available.

Conclusion

Having thorough and well-documented agreements is essential for any business with multiple owners. Meeting with an attorney to hash out these details can save significant time, money, and emotional stress in the future. Proper documentation not only clarifies ownership and control but also provides a clear framework for resolving disputes and ensuring a smooth transition when an owner decides to leave the business.

Video Transcript

As a business owner, your goal is to keep control of your company, keep a right to the profits of the company, and keep ownership of the company. Unfortunately, that is not always as easy as it seems.

Introduction to Articles, Bylaws, and Owner Contracts

I once met a gentleman who owned a company with a best friend of his, and they had talked about if the friend did certain things, the friend could get more ownership in the company. But my client said, “As far as he knew, that never occurred.” Now they hadn’t written down that they were 50/50 owners, and they hadn’t written down any changes that occurred there, but the other owner who managed the finances started taking more of the profits, started making decisions without involving my client, and his argument was that he had fulfilled the requirements that they had orally discussed for him to get more ownership interest in the company or a greater percentage.

Legal Implications of Not Having Written Agreements

And so now, according to that other owner, they once were best friends. He was now more than a 60% owner, which reduced my client’s ownership percentage to less than 40%.

A Cautionary Tale

Well, as you can imagine, my client wasn’t real happy. But when he came to me, he said, “Unfortunately, we didn’t have legal documents to clarify who owns what.” Well, what I did is say is, “Well, what has been reported to the IRS? Because something has been put in writing there. And do you have any emails that talk about ownership percentages?”

So we were able to cobble together some information, but this sad story and the years of litigation that followed highlights the importance of having clarity in writing regarding what you own, what your right to control the businesses, voting, and decision-making, and power, all of that, and your right to profits, because all of those can be separate in the legal documents.

Consequences of Non-Compliance

And if you don’t have that, you run the risk that, at some point, you and the other owner have some sort of dispute. Maybe it is over how much one of you should get paid, the percentage owned, or what the value is of the company when you go to sell. So how can you avoid all of this? Quite simply, you have it in writing, and that written form looks a few different ways.

Preventative Measures

First, whenever you have articles, so articles of incorporation are for a corporation and articles of organization are for an LLC. Those are just two separate documents. They get filed with the state. So if you have an LLC, you file articles of organization with the state. Usually, that is a pretty short document, normally about two pages.

Strategic Use of Articles and Bylaws

That is a public document, but often the bylaws or operating agreement are internal rules. Now, in a corporation, you usually have internal rules that are called bylaws. The counterpart to that in an LLC is usually called an operating agreement. So an operating agreement in an LLC is just the internal rules. It typically says, “Who are the officers? How is voting done? How are profit distributions done? What are the mechanics of the financials?” Now, in addition to the operating agreement, or the bylaws, the owners can have other agreements in place.

Registration and Maintenance

Now, here is the important thing to keep in mind. The bylaws and the operating agreement generally apply to all owners and officers in the company, but they might have some side agreements, which might be called the shareholder agreement, buy-sell agreement, or member agreement, and that is binding on the parties who sign it, usually.

I say usually because, of course, it is applicable to them, but those contracts might also be binding on other people who become owners in the future. Because what often happens is you might have two owners in the beginning, and then you have a third owner and a fourth owner come in, and they may not sign all the documents. Now, when done right, typically an attorney is involved and everybody re-signs everything so they all have the same agreements, but that is not always the case.

Key Takeaways

So to summarize, the most authoritative law is the state statute that applies to either corporations or LLCs, whatever you are. Under that, then, the next highest authority is the articles in your company, then the bylaws or the operating agreement, and finally any other contracts under that that are signed by the owners.

Usually, the articles are filed with the state, but all the other documents are usually not public information. Now you might provide them to a bank in order to open a bank account or to borrow money from a bank. You might provide them to somebody else who requests them, but usually, they are not publicly filed with the state.

Conclusion

So what is the takeaway here? Well, first understand the difference between articles, bylaws, or operating agreements at the next level down, and then any other contracts. And then make sure that you have all of your agreements in writing because otherwise there is room for misunderstanding, frustration, and some of the most expensive lawsuits.

I am talking about the legal fees, the attorney’s fees, and the length of the lawsuit. Some of the most expensive lawsuits are business owners fighting with each other because usually there was a high degree of trust and then a strong sense of betrayal. Often, they were friends. They worked together every day, and then there is a feeling of betrayal.

I don’t know how many times business owners have said to me, “I’d rather spend every last penny on legal fees than to let my ex-business partner get anything.”

The vitriol. The bitterness. The resentment. The sense of betrayal. It is so thick, and it is so emotional. These are the worst kinds of lawsuits, and they are expensive because, usually, you are fighting over the entire business and all of its assets. So what can you do to avoid this? If you have more than one owner in your company, so if it is you and a partner or multiple owners, make sure you meet with an attorney and get all your agreements hashed out.

An important part of this is a buy-sell agreement. A buy-sell agreement is simply a framework for a business owner to leave. We know, without a doubt, that business owners are going to leave the business at some point in the future. It might be through the sale of a business, but more often than not, it is either the death of a business owner or a disagreement between the business owners.

Often, it is not amicable. Often, there are misunderstandings and frustrations. And so the best way to avoid those frustrations is to create a framework for a business owner to exit the business so everybody understands what that process looks like, how do you value that person’s shares, and what are their options. All of that goes into what is called a buy-sell agreement.

So having a buy-sell agreement is a fundamental, simple thing that business owners can do to avoid very expensive and distracting lawsuits years down the road.