Who Should NOT Have an LLC

This is the third post in a five-part series. You might also want to read Part 1 - "Why LLCs Exist" and Part 2 - "Who Should Have an LLC."

Most people who start a business never think something bad will happen.  One of the most common pitfalls I see clients forming companies fall into is that so many folks think they will never have any problems.  They are super excited about their idea.  They say things like, “Hey, this is the greatest business idea ever.  Everybody says so.  I’m going into business with my friend, and we’re going to make a ton of money.  This is going to be awesome!”

Then the problems start.   They have partnership disputes, or they don't make as much money as they thought they would, or they get down the road a bit and discover they need to put in more money for something they didn't factor into their original plan.  They start using the company like a bank account, constantly moving money in and out, which compounds the problem and creates even more issues.

A pre-nup for business partners

You probably know the divorce rate in the United States is around 50%.  But what you may be surprised to learn is that the business divorce rate is significantly higher.  Unfortunately, people spend more time on pre-nuptial agreements than on operating agreements, which is a shame because they are basically the same thing.

When you go into business with someone – anyone – you need to have a plan in place for bad scenarios you don’t anticipate.  An operating agreement is a plan for how you are going to respond if the crap hits the fan.

For example, if your company is ever in a situation where you don’t have enough money, what will you do?  Are you going to shut it down?  Will you do a capital call and have all the partners put in more money?  Or are you going to take out a loan?

Answers to these types of questions need to be worked out in advance.  And everyone involved needs to know the answers because another problem I see is that many people don't look at their operating agreement until they have a dispute and make a big mess trying to resolve it.  Then they look at the operating agreement and say, "Oh, so these are the rules we probably should have followed in the first place."

Who is a bad fit for an LLC

Folks who get themselves in situations like the ones above are not a good fit for an LLC.  If you fall into one of these three categories, an LLC can be a disaster.

1. The generally uninformed.  These are folks who start a business and don't really know what they're getting into.  You should consider yourself uninformed if you are:

• going into business with someone you don't know, and/or;
• you aren't going to formalize it with a written agreement, or;
• you're planning to pull an agreement template off the internet and sign it, having no idea what it says or what it means.

2. Folks who prioritize speed over protection.  Those who say, "An LLC is easy to set up, so go ahead and set it up and we can worry about everything else later."  Then they never do.
3. Indecisive folks.  Those whose idea is, “Well, we kind of know what we want to do, but when we do it, we want to do it right, so we're not going to make a decision now.”  Then they get busy and never get around to it.

The trouble with an LLC

98% of companies formed in the U.S. are LLCs.  They are frequently put together hastily by folks trying to get a business started quickly and easily.  The problem is that LLCs do not automatically have clearly defined roles for their members.

Corporations spell out what any officer has the responsibility and authority to do, etc.  LLCs do not automatically have these structures in place.  Any member in an LLC can do anything.  They can sign checks, withdraw all the money from the bank account, sell assets, close the business down, or file bankruptcy.  LLC members have authority to do ANYTHING.

And because of how the laws are drafted, there's no protection for you if the worst happens.  

Even if you do sign an operating agreement defining formal roles, you must know everything it says and everything it means.  If one of your partners does something he shouldn’t, but your operating agreement doesn’t stipulate that he can’t do it, you have no legal recourse.  You could be signing something that says you don’t have authority to look at the books, or aren’t entitled to any of the distributions, or are required to put up more money than the rest of your partners.  These provisions would be completely illegal in a corporation, but if you sign off on it in an LLC, there is nothing you can do.  The law says you are bound by whatever you signed.

What to do instead

If you fall into one of these three categories and you are really passionate about your business idea, it would be better to set up a corporation.  I set up a lot of partnerships as corporations because they're easier when you don't have to worry about eight people having signatory authority on the bank account.

If you still want an LLC, take the time to flesh out an operating agreement and get legal advice about what questions you should be asking and how you are going to answer them.  Forming a business partnership without one is like walking a tightrope without a net – if the worst happens, it’s not going to be pretty.