Contracting Basics For Beginners

Lesson 101: The basics of business law – What makes up a simple contract?

While your contracting skills may not be the strongest, every startup entrepreneur must understand the basics in order to be successful. You will come across contracts of all sorts and having a standard understanding of them will allow you to negotiate your next contract to your advantage.

What is a contract?

According to the proper definition, a contract is:

A written or spoken agreement, especially one concerning employment, sales, or tenancy, that is intended to be enforceable by law.

In much more simple context:

A contract is nothing more than an agreement between two parties where there is an exchange of goods or services for something of value (i.e. money).

Contracts are your own set of personal laws that you create. Just about anything you can come up with and both sides agree will work.

Of course you must negotiate in good faith and the subject of the contract is legal; meaning it cannot be a contract that is breaking any laws.

Each contract will contain a promise or multiple promises for something in exchange. However, not every promise is legally enforceable. In order to have a legally enforceable promise, three requirements must be met to create a legal binding contract.

3 Requirements for a Legally Binding Contract

1. An Offer Must Be Made

The first requirement for any legally binding agreement is an offer must be made. An offer must be clear and specific regarding the type of service or quantity of product(s) for an exchange of something else.

Example 1:
"I will purchase 100 chairs from Company XYZ for $55 dollars each.

A more realistic applied example could look something like this:

Example 2:
"Company ABC will provide repair services for Company XYZ on a monthly basis. Services will be provided for 24 months and will be invoiced annually"

An important note here is the offer must be a clear. Something like “I think I would like to buy some chairs” is not an offer because it is neither specific or unambiguous of providing clear terms.   

The offer will remain open until is is accepted by the counter party. While the offer is open, you will have the ability to revoke it if a better offer is found elsewhere. 

Once the offer is accepted, it cannot be revoked.

2. The Offer Must Be Accepted

Just like the offer, an acceptance must be clear and unambiguous. For example “I Accept” is clear but “That sounds good, I will get back to you shortly” is not. You must have a clear understanding of acceptance.

The sole purpose of a contract is to allow the willing buyer and seller to enter into a commercial transaction with clearly defined terms.

Acceptance Is Negotiated

In order to have acceptance, offers and counter offers will go continue until negotiations are in agreement. This dance can go on indefinitely and can become a lengthly process with larger more complex agreements.

Chairs Example Continued:
In the chairs example, a seller may decide to up his price from $55 to $75. In that situation, my offer of $55 is rejected and a counter offer of $75 has been made. I can either accept this offer or reject it.

Acceptance Upon Receipt

There also can be a situation where the offer may not be accepted directly but can still be enforceable. Instead acceptance is based on performance such as “upon receipt of delivery”.

Chairs Example Upon Delivery:
Using the chairs example again, if the 100 chairs is delivered and I accept the delivery, then that can be legally taken as acceptance.

Additionally non-material changes – meaning changes that do not affect the commercial agreement may also be taking place at the same time. These I would recommend connecting with a laywer or speaking with legalzoom.

3. Consideration Of Exchange

Lastly, to create a valid legally enforceable contract you have to show an exchange. In legal terms this is call “quid-pro-quo“. Or in simple terms, and exchange this for that. This is known as “Consideration“.

Chairs Example:
My money for your chairs

Service Example 2:
My money for your repair services

If I said “I want to buy your chairs” and you said “sure” that would not count as a contract. With this statement we do have an offer and acceptance but no consideration.  You cannot get something for nothing. 

In order to be legally binding, you must have an offer, acceptance of that offer, and a bargained-for exchange.

Additional Helpful Notes About Contracts

Additionally, here are a few other things you should know about contracts:

Get Everything In Writing

If it’s not in the contract, it does not exist. An agreement on a handshake basis is not a legally binding agreement. Overtime memories will fade and people may remember promises incorrectly. Without the promise in writing, there is no record of what is correct. Avoid oral agreements and get it in writing.

Contracts Can Be Changed or Modified

You have the ability to make changes to a contract before and after it is “executed” – finally agreed upon and signed by both parties. 

While the contract is going through negotiations, you have the ability to change any item you see fit. That is why it is also call an “agreement” because both parties must agree to all terms.

Changing or modifying a contract after it has been signed/executed is called “amending” the agreement. This is done through an “Amendment” which is an additional document that outlines any changes to be made.

Be Specific As Possible - Never Leave Anything to Chance

When creating your agreement, never leave anything to chance. Think of any possible area that could affect your contractual agreement and make sure you are covered. This is why you see extensively long agreements for sometimes simple things.

Also later down the road the agreement becomes the path for clarity. If the agreement is ambiguous, you will certainly find yourself in trouble down the road potentially ending up in litigation or worse.

Protect yourself and be as specific as possible.

Contracts Can Be Breached

Breach means breaking the terms of the agreement. Contracts can be broken as there are legitimate reasons such as poor performance, fraud, bankruptcy, and plenty of others. Items like this should be defined in your agreement to keep either side protected.

You Can Exit A Contract Early

Lastly, a contract for a certain length of time can be exited early if defined in the terms of the agreement. For example your agreement should include a “Termination for Convenience” or at least have the ability to exit in some manner. 

Sometimes this may include penalties but it could be far more worth discontinuing than taking an additional loss.

The Do’s and Don’ts of Writing A Business Plan

Developing your business plan is one of the first steps in gaining clarity for your business venture vision. When writing a business plan, you will be faced with questions of what should you include or exclude, or what to focus on and what to avoid. 

To prevent you from making the common mistakes every starting entrepreneur makes when writing a business plan, here are the Do’s and Don’ts of writing a business plan. 

When Preparing Your Business Plan, These Are Must Do's

Involve Your Entire Management Team

It is essential when preparing your business plan to have your full management team involved. Everyone has a say and a view. Work together as a team and you will arrive at the greater solution. 

Make Your Plan Logical, Comprehensive, Readable, and Keep it Short!

You business plan is going to be read by others including potential investors, venture capitalist, and the rest of management. Keep away from writing a book and focus on the clear points and overall objective. 

Make your plan easy to read and understandable. Others will have to assist executing that plan as well. A successful plan is a simple plan. 

K.I.S.S = Keep It Simple Stupid

Spend the Time & Money Developing Your Business Plan

Show the commitment and put in the effort to create a solid plan. Utilize assistance to create your plan if needed. There are great tools and templates out there to get you started.

Articulate the critical risks, assumptions, and how your business will tolerate these

Know your weaknesses and areas that your company will be exposed. It’s essential to know where your gaps are ahead of time being proactive instead of learning after your competition has overcome your market. 

This is also a key bonus when venture capitalist and investors are looking for possible areas of exposure.

Disclose any current issues and current problems with your business

Similar to above point except focused on any internal issues or potential problems your business may have. Know these and be prepared to work through them. Identify possible approaches to overcome your challenges.

Identify Areas of Possible Financing

Proactively identify every area you can find financing for your business. Not every opportunity may turn out with cash. Plan that it will take longer than you think to get all of the money needed for your business. The fund raising process will be much harder than you ever thought it will be.

Spell Out The Opportunity For Investors

Create a section of your business plan to include the benefits for outside investors. Highlight the total ownership available to them and outline the overall deal. Make it easy for investors to see the opportunity that exists for them. This should help you with finding additional investment capital for your business.

Be Creative, Capture Attention

Don’t create a business plan like everyone else. If you want to be the 1% that standout, you cannot be like the 99% of business plans that investors come across every day. Make your business a purple cow and stand out of the crowd.

The Plan is Not the Business - Take Action and Start The Business!

As entrepreneurs we can all get lost in our minds and dreams, but an idea is worthless if you do not implement. Take the initiative and get your business started. You will learn more in just a few months of actively working in your business instead of working on your business.

This will save you tremendous amounts of time an effort when developing your business plan as you will now have had actual experience instead of ideas and concepts that haven’t been tested.

If Customers are Coming and Orders are Flowing, Delay the Business Plan

If your able to begin cash flowing your business before a full business plan can be created, that is great! Don’t work on the business, work in the business to get is going. A business is not a business if you cannot cashflow!

You can always pick up writing the business plan when orders and sales begin to slow down.

Taylor Your Business Plan to Your Target Investor Group

Similar to writing a resume for a specific job, write your business plan to appeal to your target investor group. Taylor the business plan to read towards their interest, understanding, and typical language used. This will make it much easier for your target investors to connect and understand all details in their mindset.

Potential Investors To Target:

  • Angel Investors
  • Venture Capitalists
  • Banks
  • Leasing Companies
  • Government Funding

Be Realistic with Market and Sales Projections

It is great to think you have no competition or that everyone will want your product, but that is not always the case. Use detailed market data to show the opportunities, drive the spreadsheets, and pin point the bottom line.

Anyone can fluff up their numbers, but that will show through when you cannot hit your expected results.

When Preparing Your Business Plan Avoid making these mistakes

Have Unnamed Individuals Appointed to Management

Invisible friends do not produce results! Same goes with your management team. When preparing your business plan, make sure all management is clearly identified in advance. Include resumes or profile highlights applicable to your business.

Adding someone who will join you later is no guarantee they are part of the company. They could come up with a better option and never actually join you. Your management appointments must be committed in stone.

Make ambiguous, vague, or unsubstantiated statements

Avoid putting anything on your business plan that you cannot backup with actual data. Stay away from estimated sales figures that your team is unable to produce. Prevent yourself from failure by knowing your numbers and understanding what you can do and what you cannot do! It will save you from a tremendous headache down the road.

Use Jargon That Only An Expert Can Understand

Not everyone is an industry expert. Stay away from using jargon that only a few could understand. Keep in mind others who do not know your industry will be reading this and have to understand it.

Work to simplify your business plan. Avoid describing technical products or manufacturing processes that are hard to follow. Your business plan will be useless if investors and management cannot understand it.

Spend Time & Money on Fancy Brochures, Elaborate Presentations, And Anything That is Not Meat

Fancy “flair and sizzle” is great for marketing but not for a business plan. This only waste valuable time and money that only add fluff instead of meat. Your business plan should be all meat and no fat. Adding flair will only lengthen your business plan and make it harder to follow. 

Waste Time Writing The Plan When You Can Be Making Sales

Time spent in the business to generate cash flow is time well spent. The Return on Investment you put into generating cash flow will be tremendously more than working out the best business plan ever. Your business plan will not be able to predict the future, so focus on the now and get cash flowing!

Assume Anything!

Never assume anything about your business. Anytime you assume something, it will most likely be wrong. Assumptions are based on perceptions, not facts.

Never assume you have the deal without the money in the bank. Don’t assume the market will turn in your favor without hard evidence.

The worst thing you can do is assume. It creates a false perception that always leads to failure.

Legal Structure Options For Your Business

So you are starting a business and looking to learn more on business legal structures! Great let’s get you going with the right business entity for you.

To clear things up right away, what does the word “entity” mean? In short, it refers to an organization which has a legal identity separate from its members. Each entity is a legal structure that indicates how the business will operate, be governed, and taxed. Some options are simplistic and inexpensive to set up while others will require additional paperwork and various registration & renewal fees.

In this article we are going to review the four most common types of business entities. If you are either starting your business or looking to grow, one of these entities options will most likely best suite you: 

  1. Sole Proprietor
  2. Partnership
  3. Limited Liability Company (LLC)
  4. Corporation

There is no right or wrong choice as each has their advantages and disadvantages and the best choice is not always the most obvious one either. 

To assist you with picking the right legal structure that meets your business’s needs, we put together this overview guide to the most common legal structure options for your business. 

Starting Notes

While this article is very informative, after reading this you may also decide to speak with a lawyer or accountant for additional guidance. There is no one size fits all so make sure you select the best option for you.

Also please keep in mind your initial choice for your business legal structure does not need to be permanent. You do have the option to change as your business grows and develops. For example a sole proprietor may become an LLC, and an LLC may convert to an S-Corp. 

Additionally, there are alternative business structure options available depending on the special situational need. For example a pair of doctors looking to limit their personal liability may need to set up a professional corporation or professional limited liability company. These alternative options are outlined in: Unique Business Structure Options.

Legal Structure Options For Your Business

Sole-Proprietorship vs LLC vs S-Corp vs C-Corp

Sole Proprietor

For many individuals starting their small business, the typical default legal structure is a Sole Proprietorship. That is because a sole proprietorship is the most simplistic legal structure of them all that is very inexpensive to create and straightforward to operate. That is because it is not really a separate entity compared to to a Corporation or LLC. We will get into that further down.

What is a Sole Proprietorship?

A sole proprietorship is one individual with 100% responsibility with their business. All profits and losses will be reported on the owners individual tax return.

How is a Sole Proprietorship created?

Sole proprietorships do not require any additional paperwork to establish outside of your standard tax documents. Most states do not require registering a sole proprietorship.

Typically startup’s begin with this while the business is in early stage development and later transition to another legal entity as additional debts and liabilities are taken on. If your business does not have any potential exposure to signifiant debts and court judgements, then you can stay as a sole proprietorship.

How am I paid in a Sole Proprietorship?

In a sole proprietorship, the owner of the business will be paid 100% of the profits generated. Since a Sole Proprietorship is not recognized as a separate entity, it cannot retain any form of income.

How is a Sole Proprietorship Taxed?

All income generated is considered pass through and will be taxed as ordinary income on the individuals tax return.

Sole Proprietor Overview

When is a Sole Proprietorship The Best Choice?

A sole proprietorship makes great sense for a small business where personal liability is not a concern. For example if your business is not going to be taking on any significant debts, and will not be exposed to any legal binds (lawsuits, ownership or other disputes, etc..), then a sole proprietor is a great start. 

If you are looking to scale your business further and take on exposure that insurance cannot cover, then you want to consider an LLC, or Corporation.

Are there any drawbacks of a Sole Proprietorship?

While the only primary benefit of a sole proprietorship is simplicity, there are many disadvantages you must be aware of.

No Asset Protection

A sole proprietorship provides absolutely no asset protection. That means under a sole proprietorship you the business owner are 100% liable for actions of the business. This is a massive risk if you are in a business that is exposed to lawsuits as all personal assets owned by the business owner will be threatened. 

The business owner is personally liable for every claim the business incurs and in turn, that business owner could end up losing their home, life savings and end up bankrupt (not a fun situation to be in). This is because the business owner and the legal entity are treated as one and are not separate.

Additionally sole proprietorships do not have any tax advantages that corporations have, thus owning a business structure like this only benefits because of simplicity.

No Tax Advantages

Additionally sole proprietorships do not have any tax advantages that corporations have, thus owning a business structure like this only benefits because of simplicity.

You Cannot Sell A Sole Proprietorship

It is extremely hard to sell a sole proprietorship as the value is based on the owner and not the business. The only items that can be sold are the assets of the business. Nothing else can be transferred and when the business owner dies, the sole proprietorship will terminate.

There can only be one (1) owner

By way of name, a sole proprietorship can only be one owner. If you desire to bring on additional owners, you will need to change entities to either a partnership, LLC, or corporation. 

Partnership

If you are looking to go into business with another individual or group of individuals, then you would look into starting a partnership. 

What is a Partnership?

A partnership is simply going into business with someone else besides yourself. It can either be a simplistic partnership with minimal protections similar to a sole proprietorship, or a full corporation partnership governed by a board of directors and providing limited liability. 

How is a partnership created?

Partnerships must be setup as any of the following business entities:

A general partnership is similar to a sole proprietorship except it now has more than one individual involved. This is also a very simplistic and inexpensive option to start up your business and can be created with a simple handshake.

Under a general partnership all profits and losses generated will be reported on each of the participating individuals personal tax returns. 

This legal structure does start to present some risks as now personal liability is shared between all individuals involved in the partnership.  

In a partnership, each partner is personally liable for the business related activities of the other partner(s) either good or bad.

Limited liability can be in the form of either:

  1. Limited Liability Company
  2. Limited Liability Partnership

Either option will provide more protection limiting the owners’ personal liability for business debts and court judgements against the business. They also both provide a more formal structure outlining the roles and responsibilities involved with each of the partners typically outlined in the Operating Agreement.

Additionally, owners have the ability to elect how they will be taxed (either as a corporation, or as a sole proprietorship) which allows them to take advantage of some favorable tax rates.

For more details on limited liability options, see below.

Forming a corporation is much more complicated and costly but it can be far worth it in the long run. Corporations receive much more favorable tax rates as well as provide the limited liability. 

Although less flexible than a limited liability in how profits are paid out and overall management (corporations require more oversight), they do give you the ease and ability to scale. When seeking funding for your business, most investors look for corporations compared to LLC’s.

 

Partnership Overview

How am I paid in a Partnership?

Getting paid in a partnership is dependent upon how the entity is structured. If is is structured as a general partnership or LLC, 100% of the profits will be distributed as pass through to the owners/members.

If the partnership is structured as a corporation, owners will be able to take a “reasonable” salary as well as be paid a dividend distribution.

How is a partnership taxed?

Partnerships are taxed either two ways:

  • Sole Proprietorship
  • Corporation

If taxed as a sole proprietorship, all income will be passed through as ordinary income.

Under a corporation, the partnership will face double taxation but will have more tax advantages available compared to a sole proprietorship. 

When is a partnership the best choice?

In simple terms, a partnership is the best choice if you are looking to go into business with someone besides yourself.

Are there any drawbacks of a partnership?

Any potential drawbacks are based on the elected partnership option (General, Limited Liability, Corporation) and how the business entity will be utilized. 

If you are considering a General Partnership to keep things simple, similar to a sole proprietorship, there is no asset protection and each partner is 100% liable for the actions and debts of the other.  

Limited Liability Company (LLC)

The next step towards a more formal business legal structure would be a limited liability company (LLC). LLC’s are the most commonly selected as they provide many benefits for small business owners where a sole proprietorship lacks while also being more flexible than a corporation. 

What is an LLC?

The LLC provides the flexibility of a sole proprietorship or partnership with the additional benefit of a corporate shield (called a corporate veil). More importantly, the LLC provides the limited liability where a sole proprietorship does not. 

Under a limited liability business structure, the owner(s) known as “members” of the business are now protected from any business debts and court judgements that may go against the business.

When starting an LLC, it can be a single member (similar to a sole proprietor except now has a corporate shield) and multi-member LLC’s with more than one individual involved (Similar to a partnership).

Additionally, owners will now be able to take advantage of some favorable tax rates depending on how the LLC is created and how profits are shared.

LLC Overview

How is an LLC created?

The LLC will need to be registered with your state of business and will require any legal licenses & permits. Additionally the LLC is required to file the Articles of Organization with the secretary of state.

While an operating agreement is not always required with each state, it is highly recommended as it will clearly lay out the rules and responsibilities of each owner involved.

Additionally, LLC’s have the ability to be structured either as a sole proprietorship (single owner) or a partnership (multi-owner) depending on how many individuals will be involved. In some states, single owner LLC’s are still considered sole proprietorships thus making it easy to pierce the corporate veil that the LLC provides.

 

How do I get paid in an LLC?

Members of the LLC are not employees. An LLC cannot have employees as the LLC does not pay a salary. Instead members are paid in distributions of the total profits. This income will then be passed through on the individual member’s tax return. 

How is an LLC Taxed?

Generally, under the typical partnership tax election, income generated from the LLC will be passed through to the members and counted as ordinary income. Members will then file their own tax returns each year.

Alternatively, an LLC can be taxed as a corporation opening up for various tax advantages. With a corporation tax elective, the LLC will run the exposure of a double taxation. 

It is recommended you speak with a tax advisor to discuss which election is best for your business.

When is an LLC the best choice?

LLC’s work well for startup’s and small business’ as they bring forward the benefits of a corporation and the flexibility of a sole proprietorship. You will also often see LLC’s used in real estate as they provide great business structures in this space.

Are there any drawbacks of an LLC?

LLC’s are limited on their ability to scale. Since an LLC does not payout shares of stock, outside investors are not as easily inclined to get involved. 

Additionally, as the LLC generates more revenue, the LLC could face paying some significant taxes if is it not registered as corporation.

Lastly, an LLC is not permanent and will need to be renewed every 2 years (renewing your LLC is a very simple process and can be completely managed by your registered agent).

SETTING UP YOUR LLC

How do I get Started?

Forming an LLC takes some additional paperwork but it is not very complicated to create. On average most LLC’s take under 30 minutes to set up online using a Registered Agent and will cost you anywhere from $50 – $300 depending on the state. 

Although you can set up your LLC on your own, we recommend using a registered agent as they will simplify the process dramatically for you.

Here are some possible registered agents that work well.  

Corporations

Corporations have been around the longest and were created to provide legal protection for the owners and operators of the business. A key difference from all other business structures is corporations will issue shares of stock that can be distributed to outside investors and loyal employees. They also will allow a salary to be paid to the employees compared to LLC’s distribution of profits.

Since we are focused on startup’s and small business’ we will not be discussing large publicly traded corporations and instead focus on smaller entities with one or several incorporators.

What is a Corporation?

A corporation is a legally separate entity from the individual(s) who own and operate it. You may own 100% of the stock in your corporation but as long as the operating procedures are followed correctly, the corporation will be recognized as a completely separate entity. 

This in turn provides limited liability protecting each of the operators from personal damages that may be caused by any misdeeds within the corporation such as:

  • Debts including bills, outstanding payments for equipment, etc.. (excludes outstanding taxes and personal guarantees)
  • Injuries suffered by individuals that could not be covered under insurance
  • Misdeeds of an individual within the organization

Corporation Overview

How is a Corporation Created?

A corporation can be created by a single or many incorporators and will be formed under the laws of the state where it will be registered. For example to file a Delaware corporation (most commonly used) you will need to file a Certificate of Incorporation with the Delaware Department of State.

The Certificate of incorporation includes: 

  • The name of the corporation
  • Name and address of the registered agent 
  • A statement of the purpose of the corporation
  • Total number of shares of stock being issued and the par / nominal value of each share.

Once the Certificate of Incorporation is filed, the corporation comes into existence.

Additional documentation will also need to be created appointing the first board of directors where they elect the appointment of officers, issuance of stock to the founders and initial investors, adoption of corporate bylaws, and the opening of bank accounts.

Finally to complete the process, the corporate must also obtain an EIN number and have all founders and employees sign confidentiality and invention agreements while all share holders will sign a shareholder agreement.

How am I Paid In A Corporation?

A typical for profit corporation will pay a salary to employees and dividends to shareholders. If you own 100% of the shares and are the only employee of the corporation, you will get paid twice.

How is a Corporation Taxed?

Unless a corporation is provided special treatment from the IRS, the corporation will be required to pay federal, state, and possibly local taxes.

When shareholders receive a dividend, each shareholder will pay taxes on the dividends received. 

When is a Corporation the Best Choice?

Corporations work well for cash-flowing startup’s and small businesses looking to scale and seek outside investors. Their primary benefits include providing the limited liability for the stockholders, give the ability to raise capital through the sale of stock, and corporate tax treatments.

Are there any drawbacks to a corporation?

Corporations are very structured and will require more paperwork and costs to set up and manage. For someone looking for a more simplistic business structure, a corporation would not be the first choice.

Write the LLC Operating Agreement

How Do I Write an Operating Agreement?

So you are starting a LLC! Well its time to get some legal structure and organization in place for you. The operating agreement is the first step in getting your LLC organized! 

Here we go into some of the most common questions asked when you are setting up your LLC and drafting your operating agreement.

What's In This Article?

HOW TO WRITE AN OPERATING AGREEMENT

This article is provided for educational purposes only and may not contain all necessary provisions your business may need. We advise you to speak with a business attorney for full legal advice when preparing your operating agreement.

What is an Operating Agreement?

The operating agreement sets the rules and guidelines on how the owners (known as members) will run the business.

The primary purpose is to uphold the limited liability that the LLC provides in order to prevent piercing the corporate veil.  Similar to the bylaws of a corporation, the operating agreement structures the LLC while also defining the member’s rights and responsibilities associated. 

Do I Need an Operating Agreement?

Operating agreements are used with multi-member LLC’s due to their nature of outlining percent interest and roles. This is seen with both member-managed and manager-managed LLC’s. 

While an operating agreement is necessary for multi-member LLC’s, it is also essential for sustaining the validity and protection of single member LLC’s as well.

Not all states will require an operating agreement to form an LLC but it is highly recommended one is created in order to uphold the limited liability of the LLC.

Should I Use an Attorney?

An attorney is not necessary to use an attorney to write your operating agreement. It is highly recommended to speak with a business attorney to make sure your best interests are covered when drafting the operating agreement.

How Do I Write An Operating Agreement

There are many templates out there to get you started drafting your operating agreement. Be careful on which templates you find as they could be improperly worded or could lack some of the necessary provisions needed to protect your LLC.

To assist you in your search, check out any of the following credited tools that can assist you not only with your operating agreement, but also with properly setting up your LLC.

Or if you would like to start from scratch and write your own, below are the common provisions that should be included within your operating agreement.

What should be included in the Operating Agreement?

A typical operating agreement would contain at least the following provisions:

1. General Business Details

The first section of the operating agreement states the general business information such as Name of the Business, Address, Registered Agent Information, and the overall business purpose. 

A quick tip: The business purpose does not have to be specific and can be very general such as: “To engage in any lawful business for which limited liability companies may be organized in this state.”

All of this information will already be stated within the Articles of Organization when filing the LLC.

For more information on the Articles of Organization, click here.

2. Capital Contributions

One of the most important sections of an operating agreement is the capital contributions. This section sets forth how much money or property each member will contribute to the LLC either now or in the future. 

Contributions will include monetary investments and property such as physical computers, land, or any other physical assets. Knowledge and skill sets could also be included through not deemed capital value, but still essential for the company’s overall success.

Not only will current contributions be addressed, but any future contributions are to be included as well.

3. Management

This section is to specify how the LLC is to be managed. Such management types would be either:

  • Member-Managed: This is the default and typical management method election for most small business LLCs.
  • Manager-Managed: Less common election for a small business and used for when an employee of the LLC manages the business. If you elect this option, you will need an additional section outlining how managed are selected, replaced, and what authority they will have.

4. Membership & Voting Details

The operating agreement of an LLC should include details about each member’s percent interest along with their respective voting details on how issues are decided. 

Typically this can be based on their respective capital contributions. For a member-managed LLC, a simple majority (51% or more) of the membership interest is needed to decide the issue. 

Voting can also be done on a per capita basis which means each member is given one vote no matter the capital contributions provided.

5. Tax Elections

Your operating agreement is to indicate how the LLC is to be taxed. Here the LLC can be taxed as a partnership (default) or as a corporation. Each comes with their own tax benefits.

It is recommended you speak with your tax advisor based on your unique business model for advice for selecting tax elections with your LLC.

6. Distributions and Profits & Losses

This will state how profits and losses will be allocated to each of the members within the LLC and how often will these distributions occur.  Elections can be weekly, monthly, quarterly or in certain amounts.  

All distributions elections must be stated within the operating agreement.

7. Transfer of Membership Interest

This provision describes how ownership will be transferred to another owner or add additional owners.  

For example, if an additional business partner is to be added in the future, this section will outline the circumstances when ownership can be transferred, what steps need to be taken to do so, and anything else associated with transferring ownership. 

This will also apply for if a member elects to withdraw their interest.

8. Buyout Provisions

If a member dies, moves away, gets sick, or simply wants to exit the business, this section will outline the requirements to buy the member out.  

For example the LLC could force the departing member to sell his or her interest to the remaining members and specify a timeframe to do so.  It will also outline how this will be valued and any other associated details.  

As a note this information may also be found in a buyout agreement.

9. Amendments

If you wish to make any changes to the operating agreement, this section will describe the process and how any amendments are to be processed.  Here it can be noted if consent may be required to approve the amendment if more than one member is involved.

10. Liquidation and Dissolution

Lastly, when and how should the LLC be dissolved if decided by the members.  This will include voting rights (unanimous or majority) and include all the steps to be taken to properly dissolve the LLC such as liquidation of assets and other associated properties.

Wrap Up

Overall the above are some of the key provisions your operating agreement should contain. Please note your business may have some unique aspects that should also be outlined. 

You can state any other additional provisions that are to be included such as indicating members are free to work with other businesses, or note how meetings are to be conducted. It is up to you on what you feel is am important element of your business that should be properly defined.

Remember the operating agreement can always be amended in the future so you do not need to make sure you have all details within the first iteration. It does not have to be perfect in the first draft! Sometimes keeping it simple when starting may alleviate the headache and delay of getting yourself started. 

As the world of business changes, your company should also change thus some aspects and other areas will follow. Your operating agreement will also change as your business expands and grows.

Good luck with your next adventure and enjoy the world of being an entrepreneur!

The Articles of Organization for an LLC

Starting a business and wondering what are the Articles of Organization for an LLC? In short, it is a simple key document required to be filed for your LLC to get started.

What are the Articles of Organization?

The Articles of Organization is a simple document that contains the key details of your LLC and is used when filing for the LLC with your state. Typically the state you are filing the LLC in will provide you the Articles of Organization form. You will be able to complete the form online making it a quick efficient process.

What is included in the Articles of Organization?

Typically the Articles of Organization for an LLC will contain the following:

1. Name of your LLC

This is the fun part where you get to pick a name for your LLC. The name will have to comply with state legal requirements and will require the designator “Limited Liability Company” or “Limited Company”. In most states the abbreviation LLC will also be accepted.

Here are some name variations below:

  • ABC Services Limited Liability Company
  • ABC Services Limited Company
  • ABC Services Limited Co.
  • ABC Services LLC  (Most Common Use)
  • ABC Services L.L.C.
  • ABC Services L.C.
  • ABC Services LC
  • ABC Services Ltd. Co.
  • ABC Services Ltd. Liability Co.

Warning: Your name will be rejected if it is already in use or very similar to another registered LLC. In this case you will need to choose a different name. Prior to submitting your LLC name, you can lookup all registered LLC’s on your state’s Corporation and Business Entity database prior to filing.

Check For Potential Trademark Conflicts

If the name is approved, it may still have potential trademark conflicts that should be checked. For example using “Starbuck” or “McDarrels” would be trademark infringements. It is recommended you conduct a national search to confirm the name is not going to cause any legal trademark violations. You can go to https://www.uspto.gov/trademark to access more information on trademarks.

Note: You do not have to be locked into your business name forever. If you would like to use an alternate name in the future, you can register the new name as an “assumed” or “fictitious business name” with the state.

Caution: Conducting a name availability check does not guarantee you the name. Not until the Articles of Organization for an LLC have been filed and accepted, the name is not yours. So wait on purchasing signs and business cards until all paperwork has been accepted.

2. Address of Business

As straight forward as it is, this section will ask you for your primary place of business. Here you will provide the address of your main business location. If you are a small business working from home, this will be your home address. If you are opening a storefront or office space, it will be the main location where your business will be conducted.

3. Name and Address of Your Registered Agent

Here you will provide the name and address of your registered Agent. The registered agent will the the point of contact where all legal documents will be sent relating to your LLC. This can be you if a resident of the state in which the LLC is to be registered. If you do not live in the state where the LLC is being registered, you will require a registered agent, or if you do not desire to receive all legal documents (for example being served for a lawsuit), you will want to elect to go forward with a registered agent.

Some very reliable registered agents would be Northwest Registered Agent LLCIncfileLegal Zoom, or Rocket Lawyer. These agents will not only assist with setting up your LLC but also offer services to partner with the overall legal compliance management. If you are just getting started, we suggest taking a look at some of these services to ease the process and confirm you are legally compliant when setting up your LLC.

4. Purpose

Here you will state your business purpose. Please note your purpose does not have to be specific and instead could be something like: “To engage in any lawful business for which limited liability companies may be organized in this state.”

5. Type of Management

This section is to specify how the LLC is to be managed. Such management types would be either:
  • Member-Managed: This is the default and typical management method election for most small business LLCs.
  • Manager-Managed: Less common election for a small business and used for when an employee of the LLC manages the business. If you elect this option, you will need an additional section outlining how managed are selected, replaced, and what authority they will have.

6. Duration of the LLC

This is how long will your LLC be active. Typically this is perpetual but in some states your LLC may have a cap of 30 or 50 years. In that case, you will renew for an additional period of time when needed.

7. Signatures of the members forming the LLC

Here the Articles of Organization becomes effective upon signature. With member-managed LLCs all initial members are to sign the articles of organization.

Submission

Upon completion of your Articles of Organization, you will submit this with your LLC filing for approval. Typically this is filed online and with your secretary of state’s office. In some states, (for example New York) you will be required to put a legal notice of publication in a local newspaper indicating the formation of the LLC.

Next Step: Complete the Operating Agreement

Your Complete Guide to Forming an LLC

For anyone looking to get started in their business, forming an LLC is a great way to begin.  The LLC provides you the legal protection of a corporation with the flexibility of a sole-proprietorship. 

Setting up an LLC is fairly quick and can be done at very low costs.  Follow the steps below to learn how to form an LLC.

What's In This Article?

Common Questions for Starting an LLC

To get you started, here are some common questions asked about starting an LLC.

A Limited Liability Company (LLC), is a legal business entity similar to a sole-proprietorship or partnership except it provides legal limited liability protection for the business owners and their personal assets. With an LLC, the owner of a business is personally protected against all business debts and court judgments.

The main benefit is the corporate veil that is created providing the legal protection of a business owner’s personal assets (home, car, personal bank accounts, etc..) and limit on personal liability. There are also some legal and tax advantages that can be applied as well compared to a corporation or sole-proprietorship.

People typically form an LLC when their business faces a chance of potential risk suck as a lawsuit. If your business operates in a field that has a high chance of getting a lawsuit, it is recommended to form an LLC for legal protection.

LLC’s are commonly used for small businesses and in real estate investing.

Although it is not required to use an attorney to file an LLC, it is recommended to have one review through your operating agreement to confirm proper state compliance for your business as well as to assist in protecting your best interests.

Typical costs to file for an LLC can range from $40 – $500 if filing yourself and depending on state fees. Alternatively there are also third party services that can do this for you at similar costs with additional enhanced service options.

With a typical LLC, only two documents need to be filed:

  1. The Articles of Organization (Also known as the “Articles of Formation” or “Certificate of Formation” in some states)
  2. Operating Agreement – Although this is not always required for filing, it is highly recommended to have this created.

    Read more about the required LLC paperwork

No, an LLC does not issue stock. Unlike a corporation with shareholders, owners of the LLC are called members. Instead of stock, members have their percent interest in the company. This is typically defined within the Operating Agreement.

LLC’s have the option to be taxed as partnerships or corporations.

The typical partnership LLC is taxed based on 100% of its earnings as a pass-through taxation. All earnings are filed on the members taxes at the end of the year.

See more about LLC taxes and distributions below

Getting Started – Setting Up Your LLC

Step 1 – Decide Members (Owners)

To get started, first you will need to identify if you are going to form the LLC as a:

  • Partnership (multiple members); or
  • Sole-proprietorship (one member).

This is where you will decide how many members will be involved.  If only you will be forming the LLC, a sole-proprietorship will be elected. The minimum number of members to form an LLC is one.

Do not be worried if you wish to add or remove a member in the future as this is a fairly easy process.  Typically the rules to adding/removing a member will be outlined in your Operating Agreement.  Also there is no need to notify the state when a new member is added as it will show on their tax records at the end of the year.

Step 2 – Elect Management

Depending on if you are going in with a partnership or electing to run your business on your own, you will need to decide how the LLC is to be managed. The typical default used is Member-Managed, where the members of the LLC oversee the day-to-day operations.

An alternate option is Manager-Managed where a separate level of management is elected and one or more people are appointed to manage the LLC. This election is less common for starting LLCs.

Step 3 – Obtain Financing

When looking to finance your LLC, you can either obtain it through two ways:

  • Debt (taking a loan); or
  • equity (also known as capital contributions)

Overall these are called Assets and will be outlined in the Operating Agreement when forming the LLC. Typically the amount contributed will define the member’s percent interest (capital) invested in the LLC. Also if the LLC must be dissolved later in time, this capital interest will determine the portion of LLC assets each member is entitled to.

Debt (Taking a Loan)

Taking a loan from a bank, friends & family, or other means is taking on debt. Loans can be very useful to enhance the LLC’s cash reserves or cover additional expenses.

Money taken as debt is not accounted for as income but instead a liability because it must be paid back and typically includes interest. Because of this, neither the LLC or members will pay taxes on it.

Example: In a sole-proprietorship, a $10,000 loan is made when forming the LLC. The loan has a 5% interest rate and is made repayable in monthly installments over a 36 month period. Repayment to the loan will include interest no matter if the LLC is profitable or not.

The LLC deducts the interest payments as a business expense reducing the overall profits and later total taxes paid on those profits.

Equity (Capital Contributions)

Capital contributions consist of cash, property, or services that is invested into the business from the start. This includes contributions to be made today, or in the future.

Capital investments into an LLC are normally tax free. No members have to pay taxes on their percent interest received and the LLC does not pay taxes on the capital it obtains. All taxes are deferred until later when the business is sold or dissolved. At the time of sale, exit, or dissolution, the exiting member(s) will be taxed on any profits made allocated by their percent interest initially invested.

Example: In a sole-proprietorship, a $10,000 capital contribution is made when forming the LLC. The forming member receives 100% capital interest in the business. Later when the business is sold for $80,000, the forming member is only required to pay taxes on the $70,000 profit ($80k – $10k = 70k profit).

Step 4 – Compensation Elections

Let’s Get Paid!

Deciding how money comes out of the LLC is the fun part! With an LLC you can elect to get paid either of two options:

Option 1 - Salary

With a typical partnership tax election LLC, the business can pay a reasonable salary (known as a guaranteed payment) to the members. The salary will be taxed as ordinary income and the LLC will deduct the distribution as a business expense against profits earned (i.e. Net Income). The remaining net income will then be distributed to all members.

Example: Member A and Member B have 50% ownership interest in the LLC. Member A receives a salary of $30,000 annually and Member B receives a salary of $40,000 annually. During the year, the LLC earns $100,000. At year end, Member A and Member B’s salaries are deducted as business expenses ($70,000 total). The LLC has no other business expenses outside of both salaries paid. Total remaining profit (net income) is $30,000 ($100,000 – $70,000 = $30,000). With 50% ownership, the $30,000 in remaining profit is then split evenly and distributed to each member.

Option 2 - Profit Distribution

If a salary is not taken as a guaranteed payments, then net profits will be distributed to each respective member of the LLC (known as the members “Distributive Share”). Distribution of the net profits will be determined by the percent ownership interest of each member or as otherwise stated within the Operating Agreement.

With the above example, the total $100,000 net profit of the LLC will be distributed evenly (50/50) based on membership interest. Both members would receive $50,000 at year end.

Step 5 – Select a Name

This is the fun part where you get to pick a name for your LLC. The name will have to comply with state legal requirements and will require the designator “Limited Liability Company” or “Limited Company”. In most states the abbreviation LLC will also be accepted.

Here are some name variations below:
  • ABC Services Limited Liability Company
  • ABC Services Limited Company
  • ABC Services Limited Co.
  • ABC Services LLC (Most Common Use)
  • ABC Services L.L.C.
  • ABC Services L.C.
  • ABC Services LC
  • ABC Services Ltd. Co.
  • ABC Services Ltd. Liability Co.

Warning: Your name will be rejected if it is already in use or very similar to another registered LLC. In this case you will need to choose a different name. Prior to submitting your LLC name, you can lookup all registered LLC’s on your state’s Corporation and Business Entity database prior to filing.

Check For Potential Trademark Conflicts

If the name is approved, it may still have potential trademark conflicts that should be checked. For example using “Starbuck” or “McDarrels” would be trademark infringements. It is recommended you conduct a national search to confirm the name is not going to cause any legal trademark violations. You can go to https://www.uspto.gov/trademark to access more information on trademarks.

Note: You do not have to be locked into your business name forever. If you would like to use an alternate name in the future, you can register the new name as an “assumed” or “fictitious business name” with the state

Caution: Conducting a name availability check does not guarantee you the name. Not until the Articles of Organization for an LLC have been filed and accepted, the name is not yours. So wait on purchasing signs and business cards until all paperwork has been accepted.

Step 6 – File the Paperwork

It is now time to begin working on the paperwork for the LLC. Typically only two legal documents are created when forming the LLC known as the Articles of Organization (Also known as the “Articles of Formation” or “Certificate of Formation” in some states) and the Operation Agreement. These documents will be submitted when filing the LLC within your state.

The Articles of Organization is a simple document that contains the key details of your LLC and is used when filing for the LLC with your state. Typically the state you are filing the LLC in will provide you the Articles of Organization form which can be completed and submitted online.

The Operating Agreement sets the rules for how the owners (known as members) will run the business while also defining their rights and responsibilities associated. Its primary purpose is to uphold the limited liability that the LLC provides in order to prevent piercing the corporate veil.

Similar to a partnership agreement or corporate bylaws, the Operating Agreement structures the LLC covering items such as finances, ownership details, and management responsibilities. Not all states require an operating agreement to form an LLC but it is highly recommended one is created in order to uphold the limited liability of the LLC.

Typically operating agreements are used with multi-member LLC’s due to their nature of outlining percent interest and roles. This can be seen with both member-managed and manager-managed LLC’s. While an Operating Agreement is necessary for multi-member LLC’s, it is also essential for sustaining the validity and protection of single member LLC’s as well.

Step 7 – Submit & File the LLC

Now all steps above and paperwork is completed, you may submit the LLC application with your state for acceptance.

Congratulations
on your LLC!

After the LLC is Formed

Once all documents have been submitted and accepted by your state, you will have some additional items to are either legally required to set up such as a business bank account, EIN number, make any publication notifications, and wrap up any unsettled finances. Review with your state guidelines that are necessary to complete the LLC.