Considerations for Forming a Business Entity with Multiple Partners

When starting a new venture with business partners, it is crucial to fully negotiate and document each partner’s agreement and understanding with respect to the financial and managerial rights and obligations of each party to the business relationship. While a de jure “partnership” will exist between the individuals in the event that they do not formally organize a business entity, the default partnership rules (such as those in Maryland) likely will not accurately reflect the parties’ intent with respect to each others’ rights and obligations. This is just one of many reasons that it almost always makes sense to properly select and form a legal business entity when starting a new business enterprise.

Limited liability companies (LLCs) are the vehicle of choice for most small business organizations. The reason for the popularity of the LLC form is that it combines flexibility in the ability to structure financial rights and managerial obligations with pass-through taxation and limited liability for the actions of the company and other members. This combination of traits is not available with corporations (limited flexibility) or general or limited partnerships (no limited liability for general partners). Although, combination of multiple entities (e.g., a limited partnership with an LLC as the general partner) can be used to reach similar results. This combined structure can be particularly useful, for example, where the limited partnership form is desired for purposes of shielding silent investors from personal liability and the operating partners also desire liability protection.

With corporations, ownership interests and profit sharing must be proportionate to the investments made by each shareholder, although different classes of stock can be issued to affect distinctions between shareholders’ voting rights and rights to distributions. Importantly, this option is not available for S corporations, which under the Internal Revenue Code may have only one class of stock. With LLCs and partnerships, the members or partners have more flexibility to agree to ownership shares and profit and loss allocations that vary from their proportionate contributions. Contributions can be in the form of cash, physical assets or services. Of course, the corporate form will likely be more desirable for a company with visions of going public, even in spite of the competing benefits of forming an LLC.

Whichever form of entity makes the most sense for the business, it will be in the best interests of all parties involved to have the company form and business relationship put into writing. The Operating Agreement (LLC), Partnership Agreement (Partnership) or Bylaws (Corporation) will govern the management and rights of owners of the company. Buy-sell agreements, shareholder agreements, shareholder or membership certificates, intellectual property licenses and assignments, options, notes, resolutions and other contracts and documentation may also be necessary in order to fully establish and solidify the business partners’ intended relationship. By addressing ownership, control and financial rights up front, prospective business partners can reduce uncertainty, mitigate risk, and take steps to proactively address and avoid costly disputes down the road.

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