When a Small Business Becomes a Multi-Owner Enterprise

How companies are organized, the relationship between and among owners.

 

Editor’s note: This is the first in a series on the intricacies and best practices of corporate governance on a single proprietorship small business.

For single member limited liability companies, where one person owns the enterprise, Corporate Governance is not a burning issue.

In this situation, while certain formalities, like the separation of personal and enterprise accounts, is required in order to help protect a single owner from personal liability associated with company obligations—the primary purpose for incorporating in the first place– corporate governance requirements are more relaxed.

For example:

Sole owners are not expected to keep minutes documenting their decision-making or self-enact resolutions to implement company policy. But with the admission of new owners–additional members in the case of a limited liability company (LLC), or shareholders, in the case of  a standard C or S corporation—very quickly issues of governance can rear their ugly head, as decisions, formerly being made by one person, are now subject to the review and input of others, sometimes including owners with different interests.

In this, and the next series of articles, we will explore the area of Corporate Governance and try to underscore some good practices that have general application to all types of multi-owner enterprises.

Our goal in future articles is to discuss how companies are organized, the relationship between and among owners, directors and managers, and their respective duties and obligations, but, in this article, and the next, we will be discussing the importance of having “living” operating documents.[1]

At the point that a single, owner, enterprise becomes a multi-owner enterprise, documents, in particular, the Operating Agreement, in the case of an LLC, or the Shareholders Agreement, in the case of a corporation, become important as guidance on questions such as what constitutes a quorum of owners at a meeting necessary for decisions to be considered binding on the company; how should ownership interests be valued and transferred; and how much in the way of support should be required for certain decisions to be carried, i.e. on the basis of  majority vote, unanimity, super-majority, etc.

All too often, in the case of a multi-owner enterprise, there is a tendency to operate the enterprise in the manner of a company owned by one person. The tendency is particularly strong where one owner predominates, with the ability to outvote all other owners on any issue. But, as an earlier article on Fiduciary Duties points out, that owners owe duties of loyalty and care not only to each other, but to the enterprise as well, can serve as a check on this seemingly unchallengeable authority.

A related point is that, while, most of the time, the interests of owners and the interests of their enterprise coincide, this may not always be the case; nor is it always the case that the interests of the predominate owner of an enterprise are the same as those of the minority owners.

For example

Owners who willingly misrepresent the status of their enterprise to Government agencies, such as filing false tax returns regarding the company’s income, may not only be prosecuted personally for fraud, but could be sued by the enterprise, itself, on the basis that the owners’ misrepresentations harmed the company.

Likewise, a dominating owner, who decides to sell a major asset of the enterprise, without consulting her fellow owners, could be sued for breach of fiduciary duty.

The law also allows owners, under certain circumstances, to sue other owners on behalf of the enterprise, where the company has been materially harmed.

What all this means is that as soon as a single owner enterprise becomes a multi-owner enterprise, attention should be paid to what the operating documents say about how the ownership should make decisions.

Such documents should not be relegated to gathering dust at the bottom of a desk drawer, but be subject to continuous review and revision, because issues will inevitably arise that were unanticipated, requiring operating documents to be revised.

I would add that standard operating procedures, requiring the continuous updating and revision of operating documents, should be implemented as early as possible because, as the company grows, adding new members and managers, the ability to amend documentation will become much harder.

This is because decision making, as a rule, becomes exponentially more complex as the number of owners increases, i.e. a single owner can implement company decisions almost on a whim, but a substantial effort may be required to obtain agreement among, let us say, five or more owners.

Page two: The importance of having living operating documents