LLC Formation: Why Filing Your Articles is Not Enough
Entrepreneurs are often attracted to organizing as a limited liability company (“LLC”) due to the perceived ease and cost-savings of formation. In most states, one can (technically) establish an LLC by filing a single document and paying a small filing fee. For example, in Michigan, one can establish an LLC by filing the Articles of Organization and paying a $50 fee. While filing the Articles of Organization may technically establish an LLC, more is needed in order to properly organize an LLC. This post examines the additional steps needed to properly organize a multi-member LLC.
Information Contained in Articles of Organization
The Articles of Organization are a simple one-page document that provide the following:
- the name of the company;
- the duration of the company, if other than perpetual (this is typically left blank for tech startups);
- the name of the registered agent and address of the registered office;
- the name of the “organizer” of the LLC.
Most states do not require any documentation other than the Articles of Organization (or that state’s equivalent publicly-filed document) in order to establish an LLC.
Information NOT Contained in Articles of Organization
Importantly, the Articles of Organization do not provide any of the following information:
- who holds equity in the company;
- how much equity any single person holds in the company;
- who makes what decisions on behalf of the company;
- what happens if a member leaves the company; and
- who owns the IP created by members of the company.
At the most basic level, the absence of information about who is part of the company is particularly troubling. If a founder does nothing more than file the Articles of Organization to set up a company, there is no conclusive document indicating who is part of the company. Without more, individuals could point to vague oral or email statements to claim that they are entitled to some equity interest in the company.
Your State’s Default Governance Provisions May Not Be Appropriate
Most states have LLC statutes that provide default provisions for how LLC’s operate. In the absence of additional documentation, such as an operating agreement signed by all members, these default provisions will control the operations of the LLC. While it might be tempting to rely on these default provision rather than taking the time (and perhaps expense) to think through and establish company-specific provisions, founders should be wary of their state’s default provisions. These default rules are unlikely to reflect exactly the way the founders intend to operate their company. For example, in Michigan, section 450.4502 of the Michigan LLC Act provides that (unless otherwise specified in an operating agreement) each member is entitled to one vote in making company decisions. In other words, even if interests in the LLC are divided 80/20 between two founders, they would each be entitled to one vote.
Additional Documents Needed for an LLC
The above deficiencies are why entrepreneurs should view LLC formation as requiring a suite of formation documents rather than the one-page Articles of Organization. Specifically, a startup organizing as an LLC should use at least the following:
• Operating Agreement – An Operating Agreement should be signed by all members of the Company. Therefore, it confirms whether or not an individual is a member of the LLC, and how much equity that person holds. The Operating Agreement should also specify at least: how decisions are made (e.g., what % of vote is required, and by whom, for the company to take certain actions); how membership interests can be transferred, if at all; and how profits/losses are allocated and/or distributed between members. For most tech startups, it is common to create “Units” of membership interest (similar to stock in a corporation), which are established in the Operating Agreement.
• Restricted Unit Agreements – If a startup seeks to impose “vesting” it is common to implement the vesting via a Restricted Unit Agreement entered into between the company and each individual member actively working with the company. This prior post discusses the concept of vesting. While the Operating Agreement may grant a member a certain percentage interest in the company, and the number of units that correspond to that percentage interest, a Restricted Unit Agreement will grant the company a repurchase option that lapses over time (i.e., the vesting schedule). The Restricted Unit Agreement should be clear about specifying what action triggers the company’s repurchase option (for example, a termination of service, or a majority vote of the members of managers of the company). Of course, whenever vesting is imposed (and the company’s repurchase option is less than the fair market value of the equity at the time of repurchase), holders of equity should pay attention to their 83(b) elections as discussed in this prior post.
• Proprietary Information and Invention Agreement (“PIIA”) – PIIA’s should be signed by each individual member actively working with the company. A PIIA assigns to the company rights in any intellectual property created by an individual during the course of their work for the company. PIIA’s also include confidentiality obligations requiring the individual to maintain as confidential any of the company’s sensitive information.
• IP Assignments – If an individual (such as a founder) has been working on the startup prior to the company formation, then it is likely that individual holds intellectual property rights that need to be assigned to the company. Because most PIIA’s are designed to cover intellectual property created during the course of an individual’s work for a company, they might not adequately cover pre-existing intellectual property. Accordingly, IP assignments should also be used to cover any intellectual property created prior to company formation.
Proper Organization is Important Even for Startups Planning to Convert to a C-Corp
As discussed in this prior post on entity conversion, it is common for startups to initially organize as an LLC but later convert to a Delaware C-corp when they plan to raise capital from sophisticated investors. For a startup contemplating this conversion, it might be tempting to forego the above organization documents, merely filing the Articles of Organization to establish the company as an LLC. This is not wise, however. Among other concerns, most state conversion statutes require a specified vote of the members in order to approve a conversion of an LLC into a Delaware C-corporation. In MIchigan, for example, section 450.4708 of the Michigan LLC Act requires that all members approve a conversion unless the operating agreement provides otherwise. Accordingly, absent an operating agreement, all members of the LLC would need to approve the conversion into a new corporate form. However, absent an operating agreement, it is also difficult to conclusively know who is a part of the company (e.g., who the members are). This lack of information would be ripe for an individual to later claim they were part of the LLC, but not included in the approval of the LLC to a C-corp. Therefore, even when a startup is planning to convert from an LLC to a C-corp, they should first properly organize as an LLC so that the conversion process is clearly approved by a well-defined set of members under well-defined governance procedures.
With the above documents in place, it is now clear: which individuals are part of the company and how much they own; which members make what decisions on behalf of the company; that the company owns the intellectual property related to its business; and what happens if a member’s service for the company terminates. None of this information would be clear if a startup merely files the Articles of Organization, and doesn’t take additional steps to properly organize itself. Using the correct documents to properly organize will lessen the risk of potential disputes down the road, especially if the LLC later converts to a Delaware C-corp and seeks outside investment.