Just like you shouldn’t do business on a handshake, you shouldn’t operate your business on a handshake either. But too many entrepreneurs regularly go into business without any formal documentation. If you have business partners, so-called “silent” investors, or took money from friends and family, I cannot stress enough how important it is to have the terms of these partnerships documented in a formal written agreement. Otherwise, it’s just a dispute waiting to happen.
If I had a dollar for every time a client or prospective client told me that their business partner/best friend/family member would never sue them, I’d be writing this article from a beach in the Caribbean right now.
There are a few critical questions that every company operating agreement* should answer.
Most, if not all, of the entrepreneurs I speak to are understandably anxious to start doing their “Great Business Idea.” In fact, their passion is why I love doing what I do (and why I became an entrepreneur myself). But that excitement also makes many entrepreneurs dive right in without doing some of the less glamorous, behind the scenes work. And a great example of this is not forming a business entity before launching the business.
Properly forming a business entity can reduce your personal exposure to liabilities of the business, minimize taxes, ensure that business is being conducted efficiently, help you obtain financing for your business, and prevent misunderstandings among the various stakeholders (your business partners, investors, managers, etc.).
So when should you form your business entity? Since the right entity can limit your personal liability, the obvious answer is before you taken on any significant business obligations. Before 1) signing any contracts or leases, 2) entering into any type of agreement with a third party, or 3) raising funds from others, even family and friends, you should have your legal business entity in place. While these types of relationships always start out very friendly, it’s these same relationships that will be the greatest potential source of conflict down the road.
You can protect yourself and your personal assets by understanding the difference between having your business enter into these legal relationships versus you personally entering into these relationships. And the key to doing so is forming a business entity. So what type of entity is right for you—sole proprietorship, partnership, limited liability company, S Corporation, or C Corporation?