Our new blog series on Starting a New Business began with selecting your business entity and important considerations to be made in the process of establishing your business. We also discussed key requirements and registration of your business with the Secretary of State. The next step for your business is to establish its governance structures. Many businesses—especially start-ups and closely-held businesses—establish these structures without much awareness of the legal requirements or knowledge that failing to properly establish governance structures can lead to undesireable costs and ramifications. Whether you have a limited liability company (LLC) or corporation , understanding and implementing sound governance practices is a foundational element to setting up your business for long-term success. This blog explores what business governance entails, why it’s important, and how it manifests in both corporations and LLCs.
What is Business Governance and why is it important?
Business governance refers to the system of positions, rules, and procedures which control a company. These rules address everything from determining the company’s tax election, to establishing how board members will be elected, to setting forth when the company will make distributions to its owners.
While properly setting up your governance is a matter of legal compliance, operational efficiency, and professional credibility, legal compliance is often the most critical of these factors, as it relates to maintaining the liability protection afforded by the corporate or LLC form. Many business owners don’t know that certain actions can cause a business owner to lose its liability shield and that one of these actions is failing to follow the legal rules and formalities for operating your business.
Another reason to have well-formed governance is to promote professional credibility, particularly as it relates to attracting investors. Investors are more likely to invest in businesses with robust governance structures that demonstrate that a company is well-managed and is bound by rules, checks, and balances and also communicate the rights investors will have as stakeholders.
Given the high stakes, businesses should take care to address governance issues properly from the start and as appropriate for their entity structure.
Business Governance for LLCs
Default Rules & The Operating Agreement
In many states, North Carolina and South Carolina included, state laws provide default rules concerning how an LLC is governed. These include rules about business management, voting rights, profit splitting between members, removing members, determining what happens when a member dies or becomes disabled, and more. LLCs can generally supersede these rules by adopting an operating agreement—the primary governing document of an LLC—which establishes its own rules regarding these topics. Notably, LLCs do not have to adopt operating agreements, but they should be aware that in declining to do so, they are automatically subjecting themselves to the default rules in the state statute.
Whether a business opts for the state default laws or to adopt an operating agreement, it should take care to understand whichever set of rules it is subjected to. Frequently, companies sign and enter operating agreements without really knowing what they’re signing, or they don’t enter an operating agreement but don’t really know what laws they are being subject to by default. These have real world consequences. Consider two examples:
Example #1: State Law Governs
Company has two members with equal ownership interest in the company and they opt not to enter an operating agreement. One member passes away unexpectantly. Under North Carolina law, when an LLC member dies, the member’s economic interest in the business passes to the member’s estate, the member’s 50% interest in the company is now left to her beneficiaries. The remaining member would like to eventually take on another partner but 50% of interest in the company’s profits is tied up.
In this case, the owner would likely have preferred to have an operating agreement with a buy-sell provision that required the deceased member’s estate to sell her interest back to the company.
Example #2: Operating Agreement Governs
Company adopts an online operating agreement in year 1 of operations. This operating agreement provides no way to remove a member and requires unanimous consent of the members to amend the operating agreement. Five years later, Company hires Employee. Employee excels and Company rewards Employee with a 10% membership interest in the Company. Something happens in Employee’s personal life, and Employee has to leave the Company. Under the operating agreement, Company has no legal basis to take back Employee’s membership interest and can’t amend the Operating Agreement to provide for this power without Employee’s consent. Now Company must rely on the Employee to voluntarily relinquish their ownership or otherwise continue to pay Employee distributions from Company profits indefinitely and even obtain Employee’s consent on many Company operations depending on other rules in the operating agreement.
In the above scenario, it is unlikely that the Company intended this result. It is also unlikely that they even thought about their operating agreement when making the employee a member. Now they are in a bind and have no legal recourse.
Both of these examples illustrate the importance of knowing what’s in your agreements, knowing the law, and creating rules that work for your business’s unique needs.
Management Structure
Managers. Aside from adopting and understanding the rules governing your business, another important component of governance is determining who will manage the business. An LLC’s manager is the person who manages the business at its highest level and has the right and authority to bind the company. Depending on the size of the company, the manager may also handle the business’s day-to-day operations. Management in an LLC can take three main forms: member-managed; manager-managed; or board-managed.
- Member-Managed. The default rule in the Carolinas is that all of an LLC’s members will also be its managers. This is called a “Member-Managed” LLC.
- Manager-Managed. The default member-management structure may not work for all businesses. For example, if a business gives membership interests to employees as compensation, the business might not want employees to have a management role in the company. In this case, the business will need to overrule the default laws with an operating agreement and determine that the LLC will be managed by a specifically appointed manager. This creates a “Manger-Managed” LLC. In a manager-managed LLC, the manager can still be (and frequently is) also a member, but the member’s management power comes from their appointment as manager instead of by virtue of their membership status.
- Board of Director Managed. While less common, some businesses may opt to appoint a board of directors to manage the business. This option would be selected if the company wanted to demonstrate more accountability and oversight in its decision-making. This might be the case if the business is looking to attract larger investors.
Officers. While all LLCs will have a manager, they do not have to have officers (presidents, CEOs, Vice presidents, secretaries, etc.). However, sometimes a business’s managers may want to appoint individuals to these roles to help clarify roles and responsibilities. If a company appoints officers to carry out operations, it’s important to determine the extent of the power and authority delegated in the operating agreement.
Corporate Governance
Corporations have a more formal and structured governance system than LLCs. Corporations must appoint a board of directors, adopt bylaws, and conduct annual meetings of the board and shareholders. Even if the corporation’s management, board, and shareholders are substantially the same individuals and observing these steps feels redundant and impractical, the corporation must still adhere to these formalities to remain legally compliant.
Board of Directors. Both North Carolina and South Carolina law require that all corporate powers are exercised through or under the direction of a board of directors elected by the shareholders (or otherwise, the Articles of Incorporation or the shareholders by written agreement may provide for these powers to be exercised by an individual to the same effect). Both states require that this board consist of at least one person. Frequently Bylaws will add to this and require an odd number and more than one director to avoid a deadlock with decision-making and provide accountability. The bylaws might also provide additional qualifications regarding age, background, expertise, or other matters pertaining to the specific needs of the corporation.
Bylaws. The board of directors will then adopt Bylaws. Bylaws are the corporate counterpart to an LLC’s operating agreement and are the corporation’s governing documents. There are a few significant differences though. First, a corporation must adopt bylaws, while adopting an operating agreement is optional for an LLC. Second, while an Operating Agreement can generally supplant the rules of the statute, bylaws are subject to the corporate statutes and can’t adopt rules contrary to what’s contained in the statutes.
Officers. As is the case with LLCs, a corporation is not legally required to appoint officers. However, if the company’s bylaws require the appointment of officers, then it must comply with the bylaws’ requirements. This is why it is important for a business owner to understand what is in the document it signs and ensure it works for the corporation. For example, a closely held business with one shareholder, one board member, and one officer, doesn’t really need to include requirements that the company must appoint a vice president, secretary, and treasurer.
Shareholders. Shareholders in a corporation have a number of rights within the company. Unless a business takes care to properly separate its shareholders into classes, they will have the legal and irrevocable right to elect the company’s board, vote on major company decisions, and review certain financial and business information regarding the business.
Within a corporation, the bylaws, board of directors, shareholders, and officers are closely intertwined. The shareholders elect the board of directors, the board adopts the bylaws and appoints the officers, the officers have the rights and authority set forth in the bylaws. In operating a corporation, it is an important matter of compliance to ensure that the proper personnel are performing the proper functions within a corporation.
Conclusion
For LLCs and corporations alike, robust governance structures provide a roadmap for both effective operations and legal compliance. While understanding, creating, and adhering to governance structure require diligence, taking these steps is an important aspect of building a solid foundation for a business’s growth and mitigating problems in the future. The attorneys at Skufca Law are here to help you establish governance that works for your businesses to lay the groundwork for the long-term success and sustainability of your business. Contact Skufca Law at (704) 376-3030 today to assist you with establishing your business’ governance.
Next up in our Starting a Business series, we will discuss issuing equity to owners and all the facets to consider when doing so.