BUSINESS FORMATION & OPERATING AGREEMENTS

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Business formation and operating agreements are primarily used when a business is owned by more than one person or entity, and the specific type of agreement depends on the legal structure chosen for the business. There are three main legal structures for undertaking business, with those legal structures largely determining the need and form of business formation and operating agreement:

  • Sole Proprietorship: The simplest structure, owned and operated by one person. There is no separate legal entity. A formal agreement is generally not needed as there are no other owners.

  • Partnership: Two or more individuals or corporations carrying on business together with a view to profit. The key agreement here is the Partnership Agreement.

  • Corporation: A separate legal entity from its owners (shareholders). The key agreement for multiple owners is the Shareholders' Agreement (often called a Unanimous Shareholders' Agreement or USA).

Although partnership agreements and shareholder agreements share similar objectives, the differences in legal language and construction emanates from the structural differences between partnerships and corporations that must be appropriately accounted for in the legal documentation, which includes the specific legal language utilized in their respective business formation and operating agreements.

A. Partnership Agreement (for Partnerships)

A Partnership Agreement is a contract between the partners that governs the business operations. While a partnership can be formed by a simple verbal agreement, a written agreement is highly recommended to override the default rules of provincial Partnership Acts and prevent future disputes. Key aspects that are addressed in a Partnership Agreement typically includes:

  • Partnership Name and Purpose: The legal name, business address, and nature of the business.

  • Capital Contributions: The amount and type of initial contributions (cash, assets, time, effort) from each partner.

  • Profit and Loss Distribution: How profits and losses will be shared (often by percentage, which may or may not be equal).

  • Roles and Responsibilities: The day-to-day duties, operational responsibilities, and time commitment of each partner.

  • Decision-Making: Voting rights (e.g., equal vote, proportional to ownership) and which decisions require a majority versus a unanimous vote.

  • Partner Exit/Admission: Rules for the withdrawal, retirement, death, or disability of a partner, including buyout terms and business valuation methods.

  • Dispute Resolution: A mechanism for resolving conflicts (e.g., mediation, arbitration). Dissolution: The terms and process for winding down the partnership.

It should be noted that with a General Partnership, partners have joint and several unlimited personal liability for the partnership's debts. A Limited Partnership (LP) or Limited Liability Partnership (LLP) offers some partners (limited partners) or all partners (LLP, typically for professionals like lawyers and accountants) some degree of limited liability, but these are subject to specific provincial legislation. More on Partnership Agreements.

B. Shareholders' Agreement (for Corporations)

A Shareholders' Agreement is a contract among the shareholders of a corporation and sometimes the corporation itself. It works alongside the corporate governing legislation to manage the relationship between the owners and the company. Key aspects that are addressed in a Shareholders' Agreement typically includes:

  • Ownership and Shares: The percentage of ownership and types of shares held by each shareholder.

  • Corporate Governance: The composition of the Board of Directors, directors' and officers' duties, and special voting thresholds for significant corporate actions.

  • Financial Matters: Rules on distributing profits (dividends), reinvestment policies, and compensation for shareholder-employees.

  • Share Transfer Restrictions: Rules to control who can own shares, such as a Right of First Refusal if a shareholder wants to sell, or "shotgun clauses" to resolve deadlocks.

  • Exit Strategies: Provisions for the death, disability, or termination of a shareholder, often including mandatory buy-sell mechanisms.

  • Confidentiality and Non-Compete: Clauses to protect the corporation's interests.

It is important to recognize that a corporation is a separate legal entity, such that it offers its shareholders limited liability (protecting their personal assets from business debts, unlike a general partnership). So whereas partners are directly liable for the business' indebtedness (with certain limitations for limited partners), as well as reporting business income/losses on their personal tax returns; the corporation is a separate legal person from its shareholders, with the corporation paying corporate tax (with shareholders separately paying tax on their actual receipt of profits (i.e., via dividends, salary) from the corporation). More on Shareholders' Agreements.

Providing strategic legal advice and direction to business entrepreneurs seeking to structure and form their business, be it as a sole proprietorship, partnership / joint venture, or corporation engaging in commercial activities in Alberta. Contact our law firm at Chris@NeufeldLegal.com or 403-400-4092 to schedule a confidential initial consultation for your new business enterprise.

Importance of a Partnership Agreement