How to Form a Business [Part 2]

This is Part 2 of our 3 part series on How to Form a Business.You can read part 1 here.

Draft an Operating Agreement

The Operating Agreement is the “Constitution” which guides the business. It spells out the purpose of the business, any contributions of cash or labor by partners, the respective ownership interests, assigns profits and losses, details management powers, and details when and how ownership interests will change hands.

If you are forming a single member LLC, you do not absolutely have to have an Operating Agreement. However, if you have a partner or more, you should definitely have an Operating Agreement, and I recommend you spend some time hammering out the details.

One of the most important sections of the Operating Agreement is the “Buy-Sell Agreement,” which determines how to value the business if the partners have a falling out and one of the partners wants to leave, or if the other partners want to force a partner to leave. If the business has grown to a decent size, and the partners are going their separate ways due to major differences or disputes, then chances are they aren’t going to agree on the value for the business. The Buy-Sell Agreement should explain how the business will be valued, and on what terms one partner will depart.

In an ideal world, when you are drafting the Operating Agreement, you and your business partners would each have your own legal counsel to advise you and represent your individual interests.  However, because many new businesses begin on a shoestring, partners in a new business often can’t afford separate lawyers or even one lawyer to represent them all.  Even having one lawyer drafting the operating agreement on behalf of all the partners isn’t the same as having each partner with an attorney looking out 100% for just their interests.

I have mixed feelings about this issue. Many lawyers will argue in a quite self-serving way that new business partners absolutely must have their own separate lawyers to represent them in the drafting and negotiation of the operating agreement.  Many lawyers say that self-help websites such as LegalZoom or U.S. Legal Forms provide operating agreements that cause more trouble than they’re worth. I agree that it’s far preferable to hire a lawyer to customize an Operating Agreement to your unique situation, and that any cookie cutter operating agreement purchased for bottom dollar on the web is probably going to cause problems.

However, I know that certain shoestring businesses wouldn’t start at all if they had to spend hundreds or thousands of dollars on hiring a lawyer right at the beginning. Also, a basic operating agreement can be fine if partners are able to get along and agree on most issues, and work things out when they disagree. So I don’t fully agree that there is no place for web-based legal document providers which sell affordable legal documents such as Operating Agreements.

(Having said that, I now need to add in the typical lawyer-esque qualification: if you do rely on an inexpensive, cookie cutter Operating Agreement you purchased online, be aware of the risks. As soon as your business starts generating profits, you may want to invest in crafting a more tailored Agreement.)

File the Articles of Organization

The next step is to file the Articles of Organization form (LLC-1) with a $70.00 fee with the California Secretary of State’s office.  It is a fairly simple, straightforward form. You can’t legally operate as the LLC or open a bank account until this document is filed.

Apply for an Employer Identification Number (EIN)

Next, obtain an Employer Identification Number, otherwise known as an “EIN” or Federal Tax Identification Number. Your EIN will be used by the IRS to identify your new LLC. You can get an EIN in less than 5 minutes directly from the IRS website.

Pay $800 to the Franchise Tax Board

Unlike a corporation, an LLC is a pass-through tax entity, meaning that you pay income taxes on any income which comes through the LLC, while the LLC does not pay taxes on the revenue generated.  You can make the payment directly on the FTB website. You can also schedule a payment up to a year in advance, which is very convenient.

Separate Your Personal Assets from the Business Assets

The number one problem with operating an LLC isn’t the fact that people don’t set up a LLC to begin with; it’s that people set up an LLC and then don’t conduct business exclusively through the LLC. They commingle their business funds with their personal funds in one checking account. They don’t sign contracts in the name of the LLC. They don’t purchase goods in the name of the LLC. They might as well have never formed the LLC because the LLC can’t protect you from liability if you use your own personal name to conduct business.

It’s like buying a bulletproof vest and then leaving it hung up in your closet. It can’t do you any good unless you use it.

Once you have set up the LLC, you should open a separate bank account in the name of the LLC. You should get good insurance which is appropriate for your line of work. Any assets should be held in the name of the LLC, such as a website or a blog or equipment. Any contracts with equipment or goods providers, or subcontractors, should be between the subcontractor and the LLC, not you personally.

The problem is many savvy business people will not do business with just an LLC, and will require a personal guarantee from the owners of the LLC. For example, commercial landlords often require a personal guarantee as part of a new lease, especially if the LLC is brand new. If you are able to sign a lease with a landlord who insists on your personal guarantee, try to limit the number of years of the lease or put a cap on your personal liability.  If the business does fail, you don’t want to have to declare personal bankruptcy as well because of your long-term personal liability for the commercial lease.

Please check back for Part 3 of our series on How to Form a Business, which will cover how to establish a separate address for your business, launch a web presence, and identify some of the common mistakes with LLCs to avoid.

You can also read Part 1 here.

Questions? Comments? Feel free to leave a comment below.

John Corcoran

John Corcoran has worked in Hollywood, written speeches for President Bill Clinton and lost his job when Arnold Schwarzenegger became the Governator. Even though he's lived in California most of his life, he is the world's worst surfer, although he does speak Valley Girl fluently. His day job is working with small business owners and entrepreneurs as a lawyer and business advisor.

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