Five Expensive Mistakes When Forming a New Jersey LLC


New Jersey Limited Liability Company Attorneys

Imagine that the limited liability company you and your partners started five years ago is involved in a nasty corporate governance lawsuit.  Perhaps one of the partners needs to be expelled, or maybe one of the owners is involved in a competing business.  Imagine that you are spending tens of thousands of dollars every month on legal fees, that the business is in a state of constant disruption and that you haven’t had a good night’s sleep in weeks.

And now, accept the fact that this could have been avoided.

The chances are that if a closely held business is involved in this type of litigation it is because the owners did not plan well when they started the business.  How do I know?  Having litigated many of these matters over the years, I see the same mistakes made early in the life of the business surfacing again and again as the source of litigation.

New Jersey Limited Liability Company Operating Agreement

This is my non-exclusive list of what I think  are the most expensive mistakes that I see people make in their business.  There are others, to be sure, but these are the ones that I see as the source of litigation among the members.

No Operating Agreement:  Actually, I am not going to count not having an operating agreement as one of the five “mistakes.”  It is not really a mistake, it is a colossal blunder, kind of like drunk driving – you may get away with it for a while, but you know how it’s going to end.

If you have more than one member of a limited liability company and you don’t have a written operating agreement, please keep my number handy.  (New Jersey does not require a written operating agreement.)  If a business does not have one, sooner or later, it will have problems and without any point of reference whatsoever, the probability of litigation is high.  When that happens and the business is successful, the chances are that you will spend the price of a college education – at a nice private school – on the lawsuit.

Mistakes to Avoid When Starting an LLC

For those companies that at least have an operating agreement, here are the five of the costliest areas in which limited liability company owners make the mistake of not planning carefully.

  • No Operation Planning: Many operating agreements don’t try to distinguish between what is day-to-day management and what are “members” matters requiring approval of a majority or all of the members. There is a difference between leasing a new copier and acquiring a competitor or buying a building.  Companies that devote the same attention to both types of issues are headed for trouble.  And it only gets worse when one person can veto the decisions of the rest of the owners.  Often people come to a business with specific skill sets and expect autonomy, but just how much autonomy will the individual members be given?  How will you manage the day-to-day?  How will you manage the really big issues?
  • No contingency Planning: The owners of limited liability companies often don’t plan adequately for the unexpected.  Life happens and the time to think about the contingencies of life is before they occur.  One of the members may die or become disabled.  Some may have children that they want to bring in the business.  Sometimes the members are, or will get married, and then get divorced.  What happens if a member develops financial or personal problems and has to be removed?  What happens when one quits to start a competing business?  Suppose that one of the members gets divorced and must pay half of his or her interest to an ex-spouse.  How will you manage these issues?  If they aren’t planned for, they likely will become the source of expensive litigation.
  • No valuation planning:  Despite the best efforts of all involved, a divorce is inevitable.  Sooner or later, someone is going to leave even the most successful business.  Sometimes, it is simply because one of the members wants to retire.  Other times it is because of poor planning or personality conflicts.  For whatever reason, the members need to go their separate ways, and this happens for an infinite of reasons, many of which are unforeseeable.  Still companies often fail to build into their operating agreements a way to value the interests of those involved.  Will the company hire an appraiser or build a formula for valuation into its operating agreements, put the method in its operating agreement or just leave the issue to a judge to decide? Many operating agreements taken out of a form book use a book value system to value the interests of its members, which are usually unfair to the departing member because they do not adequately include the value of the company’s good will, or because they fail to consider the above-market income distributed to most owners of successful businesses.  Litigating the value of a business is expensive and uncertain.  How does your business plan to make these difficult valuation decisions?  Leaving it to a court to decide is the worst possible alternative.
  • No succession planning:  We all hope when we start a business that it going to last a lifetime and beyond.  In every successful business there will come a day when the founders will no longer part of the business.  What I mean by succession planning is more than simple retirement planning.  It is how the business will carry on when the founders are gone.  And yet, even though most business owners hope their work will endure for more than one generation, they fail to plan for the succession of their interests.  Will the business admit new remembers to replace the outgoing members?  Will the family members of the business be permitted to acquire the founders’ interests?  Can those interests be passed by will or intestate succession?  These issues can be fertile ground for disputes.
  • No planning for amendments to the Operating Agreement:  An operating agreement is a contract and, like any other contract, it requires everyone to agree to any changes before they can become effective.  And because you cannot change a contract over the objection of the parties, it gives each of the members a minority veto.  Imagine that all but one of the members wants to admit another member or merge with another business?  The minority member may veto actions that are for the good of the business for any or no reason.  An effective operating agreement contains mechanisms for amendment that are planned for in advance.

The central point here is that it is a bad idea not to plan the operations of a business before there is a vested interest in the outcome – that is before a dispute develops.  Formbook operating agreements or contracts drafted by non-lawyers may serve some purpose, but they are rarely adequate.

The beauty of a limited liability company is that it can be almost anything that you want, but that takes thought, a bit of effort and is not something that should not be left to chance.  And remember, the money that you save later will more than justify the expense of doing it right in the first place.

Please fee free to contact us if you have any questions or comments.

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