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Small Business Formation Guide: By-laws, Operating Agreements, and Partnership Agreements

Small Business Formation Guide: By-laws, Operating Agreements, and Partnership Agreements

When acquaintances or family members decide to go into business together, to save money, they generally forgo formalities that are not legally required. They assume matters can easily be resolved amongst family or friends. However, it is often the case that once a business starts turning a profit or failing, people start looking out for their own interests. Tenuous handshake agreements are no longer honored and there is no clarity on how the business should proceed or cease operations. A solution to preventing or easing problems when ownership interests are held by multiple people is to have a formal written agreement such as by-laws, an operating agreement, or a partnership agreement that regulates the operation of the business. Without by-laws, operating agreements, and partnership agreements the relationship between owners of the business is regulated by the applicable state laws that may differ from the intended arrangements of the owners.

Businesses also should draft written by-laws, operating agreements, or partnership agreements during the formation stage as the documents may be needed when conducting the initial business of the entity or in seeking financing. Best practices dictate that lenders will want to review entity documents to determine who has authority to act on the business' behalf. Lenders or investors will want to review these documents even if they are not required to be written under state law, especially for multi-member companies. Therefore, a small business will want to be prepared when seeking financing and have the documents in order when approaching lenders or investors.

Corporate By-laws

Similar to the Illinois Limited Liability Act, the Business Corporation Act of 1983 (805 ILCS 5/ et seq.) governs the formation of Illinois corporations. A business seeking to incorporate should start with:

  • deciding on a corporate name and the purpose of the corporation;
  • determining who will serve as a registered agent;
  • defining what shares will be authorized; and
  • identifying who will serve on the initial Board of Directors.

Once these matters are determined, file Articles of Incorporation with the Secretary of State. The Articles of Incorporation should include the names of the initial Director(s) chosen for the business.

The next steps should include holding a shareholder meeting to establish by-laws.  By-laws just like operating agreements, are not required under Illinois law but they are strongly recommended especially for closely held corporations. If the by-laws are established by the shareholders, the corporation's initial directors also may adopt by-laws (805 ILCS 5/2.25) and (805 ILCS 5/2.30).

By-laws of a corporation should cover, at minimum, the following:

  • The purpose and corporate powers
  • Corporations name, place of business and registered agent
  • Regulation of shares: authorization, issuance, classes, redemption, etc.
  • Regulation of shareholders: liability, meetings, voting, preemption rights, and informal actions
  • Distribution
  • Amendments of by-laws or articles
  • Election, removal or resignation of directors and officers
  • Liability and duties of the officers and directors
  • Indemnification of officers, directors, and agents

If a business has designated itself a close corporation under 805 ILCS 5/2A.45, then it will need to make sure to follow Article 2A of the Business Corporation Act to define shareholder duties when the business is managed by said shareholders and not a Board of Directors.

Limited Liability Company Operating Agreement

The Illinois Limited Liability Act provides that members may enter into an operating agreement.  Yet, it is advantageous for an LLC with more than one member to enter into an operating agreement to regulate the affairs of the business and management of the business to prevent unnecessary problems down the line when questions arise such as who has authority to do to what on behalf of the company.

Under Illinois law, it is recommended that an operating agreement includes the following:

  • Designation of the management structure, e.g., manager-managed or member-managed
  • How to elect, remove or replace a manager
  • Relations of managers and members to third parties and each other
  • Contribution, Membership interest, and distributions
  • Admission, removal, and disassociation of members
  • Dissolution of the company

It is important to note, that the Illinois Limited Liability Act requires all members of a company, irrespective of the percentage of their contribution or interest holding, to consent to the following actions that cannot be altered in an operating agreement:

  • amendments to Articles of Organization or Operating Agreement;
  • certain matters dealing with contributions and redemption;
  • admission of the new members dissolution of the company; or
  • disposition of substantially all of the business's property.

Moreover, An operating agreement should not place burdensome restrictions on members, i.e., restrict their ability to disassociate, or eliminate obligations of good faith and fair dealing by managers and members. The agreement may also define or restrict fiduciary duties other than the duty of care.  However, specific duties explained in Section of 180/15-5(b)) (c) and (d) of the Act cannot be altered or waived.

Partnership Agreement

Finally, small business partners also are encouraged to formalize the scope and procedures of their operations in partnership agreements under the Illinois Uniform Partnership Act (805 ILCS 206).  At a minimum, partnership agreements should include the following:

  • Scope and nature of partnership – general or limited
  • Management of the partnership
  • Procedures for admitting or removing, and withdrawal of partners
  • Partner contributions and distributions
  • Dissolution of the partnership

If you are in the process of forming a small business or are already operating and need assistance with creating or amending your by-laws, operating agreement, or partnership agreement, you may contact McKenna Storer at 312.558.3959. Contact Jaime Dowell for questions about this article or related matters.

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