Form Docs Foil Your Startup Success

Form Docs Foil Your Startup Success

Form Docs Foil Your Startup Success: When it Comes to Operating Agreements and Bylaws, There’s NO “One Size Fits All”

By Keith Strahan

Picture this. A new business owner (we’ll call him Richard), enthusiastic about a prospective business venture, picks a filing structure and files the appropriate documents with the Secretary of State. Richard and his 50/50 co-founder make a great team and each person knows the strengths they bring to the table. After paying the filing fees, receiving a Certificate of Formation (which gets stuck in a folder in a drawer somewhere), and printing off the operating agreement or bylaws provided by a legal website, Richard and his co-founder divert 100% of their attention to development, sales, marketing, and general business sorcery.

Sound familiar? If it does, make sure you’re sitting down – we have a lot to talk about.

The problem. A successful startup formation consists of two critical parts: (1) Filing the necessary forms with your Secretary of State, and (2) Creation of solid internal operating documents. Now, I’m not going to pretend this second part is fun, sexy, or otherwise enjoyable for founders, but what I will tell you is that failing to properly draft internal operating documents right out of the gates that accurately outline roles, responsibilities, key functions, and dissolution can have disastrous consequences. When a potential client calls my firm seeking legal counsel in a partnership dispute within a closely-held business, 5 times out of 10 there is no written operating agreement or bylaws. The other 5 times out of 10, a form document was taken off a do-it-yourself website and neither party knows what it contains. By this time, each party is looking at thousands of dollars in legal bills and months of headaches.

Here’s where my plea to you comes in: Please, please, please draft a carefully considered and negotiated internal operating document for your business.

The basics. If you have an LLC, this document is called an “operating agreement.” If you have a Corporation, this document is called your “bylaws.” (Note: For startups with multiple founders, you will also need a “shareholders agreement” or “founders agreement.”) Functionally similar, operating agreements and bylaws dictate how your business is run. Imagine if before getting married, you could determine exactly who gets the remote on which nights, what temperature the house will be kept at, who is in charge of what chores, how many kids you will have, how arguments will be settled, and who gets to keep what if things go south. Sounds fantastic, right? Operating agreements and bylaws allow you this level of certainty for your business. As a wise man recently told me, business partnerships today last longer than most marriages, so you want to iron out these nuances ahead of time in a “startup pre-nup” tailored exactly to your needs, assets, and growth.

Write. It. Down. Leaning on anticipated procedures and rewards embodied in oral or implied internal operating documents can result in years of investment, labor, and care being for nothing. Even if these oral or implied operating documents are eventually enforced, the process of doing so is challenging, expensive, and unclear. While a written internal operating document is not required in all jurisdictions, one thing all business attorneys agree upon is that having one is highly, highly recommended.

Whose “de-fault” is it? If an issue arises within an organization that has failed to properly protect itself (either by not having an internal operating document or by having a form document and not following the formalities contained within), state default rules automatically apply. These aren’t short and sweet default rules, either. The Texas Business Organizations Code copy in my office is over 500 tightly-packed pages long. One especially troublesome default rule for Texas LLCs is that they are “member-managed,” meaning that any member of the company can bind the company into third-party contracts or debts and that any organizational decision must be approved by all members. This would be a horrible situation for founders with several small investors, founders who have given away bits of equity in exchange for services like a website or app development, or if the founders themselves have unequal authority and weight within the company. Carefully crafted operating agreements and bylaws can override state default presumptions and affirmatively state the form of management and the scope of the management team’s authority. Why on earth would you want to leave your company operations up to state legislators?

There’s no liability shield for stupid. When acting appropriately under the umbrella of an LLC or Corporation, you are afforded a limitation on your liability. The liability limitations are largely the same between LLCs and Corporations, so in either universe, liability is generally limited to the business entity itself and not to the individual actors (admittedly this is a very surface-level description, but you get the point). However, if you ignore the governance provisions that are laid out in your operating documents, courts and keen litigators will have grounds to question the legitimacy of your organization. When this happens, the coveted liability protection that you once enjoyed under your LLC or Corporation may vanish right when you need it the most. Woops!

“Customized” Doesn’t Always Mean “Customized.” Many legal websites and have formation packages that include a “customized operating agreement” or “customized bylaws,” but this usually consists of clicking a few buttons and having your company name auto-filled into the paperwork. If you can’t articulate, without looking, the details of your operating documents… they aren’t customized. Properly drafted operating documents mirror the way you run your business and memorialize the policies and procedures you care about most. Even if you use an attorney to prepare your operating documents, red flags should fly up if you are given a stack of papers without being asked specific, intricate details about your micro and macro business operations.

Make potential investors happy. If you are a startup who anticipates raising capital at any point in the life of your company, pay close attention. Investors want to see that you have put the time and effort into your business that is indicative of an investable foundation. Having operating documents that set out the rights and powers of owners or shareholders, voting thresholds for approvals of various company actions, and the procedures for selecting leadership and entering into debt, are critical aspects of the “investability” of your company. This is true because, to varying degrees, investors are always looking to invest in you as well as your business. Future capital raises are always important factors to address in your operating documents and should be delicately considered by you and your startup lawyer, not an internet robot.

Wrapping things up. Drafting the right internal operating documents for your business does not have to be expensive, but it does need to be done right. Many law firms such as the Strahan Law Firm, PLLC in Houston, TX cater specifically to startups and small businesses and will have affordable prices that fit your budget. Most of the time, your initial consultation is free so you can interview as many firms as you’d like until you find the best fit. If you decide to go the do-it-yourself route, I recommend using form templates only as guides to ensure you do not leave out any important considerations. Don’t copy and paste from the forms. Instead, block a few hours out of your schedule to discuss with your co-founders how you want your business to operate—call it “future-proofing.” A couple of hours now will save you countless later, trust me. Now that you’ve read this article, here are your next steps:

  1. If you have operating documents, read them judiciously. Underline everything you don’t like, weren’t aware of, or need further clarification on. Make a list of things that were ignored or left out.
  2. If you don’t have operating documents, skip to step 3.
  3. Pick up the phone and consult an experienced business attorney who can answer any questions or concerns from step 1 and who can detail the steps required for amending or replacing your operating documents, if needed. If you don’t have operating documents, talk with the business attorney about how to tailor some to fit your needs, abilities, expectations, and growth. You’ll be glad you did!