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Tanner:
This week on the show, Ashley Smith from AGS Law joins me to talk about how early stage founders can protect themselves from legal problems when forming partnerships. Ashley has some amazing advice for what needs to be included in an operating agreement and some common mistakes that a lot of entrepreneurs make when they form their partnerships. This episode has a ton of value, so stick around. Welcome to the show. Ashley, I’m super excited to have you. Go ahead and introduce yourself to the audience.
Ashley:
Thanks. I am Ashley Garbe Smith, and I’m an attorney here in Salt Lake City, Utah.
Tanner:
Awesome. So what’s your story? How long have you been practicing law?
Ashley:
So before I was an attorney, I actually was a professional musician for almost 20 years. And while I was doing music professionally I wasn’t making a lot of money because musicians just don’t really make a lot of money. So I was a paralegal at a law firm for almost 10 years and it was a litigation firm and I really, really enjoyed it. And so I ended up going to law school a little bit later in life. I had two kids and I decided to go back to law school. And so I went in, when I was 30, I went back to law school and then I ended up going back and working for that same litigation firm where I was a paralegal for several years. And I realized that litigation was making me very unhappy. And I would watch these clients, these business clients and these entrepreneurs get involved in lawsuits. And I would think, and I would even say to my senior partner, if I could just talk to this business owner at the outset, when he started his business, this lawsuit could have been completely avoided. And so I just decided that’s what I was going to do rather than fight in court with other attorneys. I was going to help businesses and entrepreneurs stay out of court. And so I ended up leaving the litigation firm in 2020, right in the middle of a pandemic. And I started my own law firm.
Tanner:
That’s an awesome story. And it just goes to show, it’s never too late to follow your dreams and do what you want to do. Right? You started your own practice in the wake of the pandemic. I’m sure that was a big challenge. What are some of the challenges that you have faced since starting your practice?
Ashley:
Well, I think the biggest one is when you are in law school, they do not teach you how to run a business. They, they don’t even really teach you how to be a lawyer. If we’re being completely honest, they teach you how to think. And then all of a sudden you get thrown to the wolves as a new attorney, and you really have no idea what you’re doing. And so it’s good to have a mentor, but they don’t teach you anything about running an actual business and a law firm. And if you talk to some lawyers, they’ll tell you that a law firm owner isn’t a business owner, they’re a professional. And I just think that’s bull crap because you have to know how to run a business. And so as a lawyer owning my own firm, I wear a lot of hats. I have to do marketing, networking, accounting, and HR, yet I still have to practice law because I’m the lawyer, I’m the one who does most of the work. I also have to be there for my clients. So I think the biggest challenge is learning how to manage my time so I can wear all of those hats, but also just learning how to be a business owner.
Tanner:
Yeah. And it’s funny that you say that because I don’t think business school teaches you how to run a business, either. I went to business school got a degree in marketing and I can’t tell you how unprepared I was down to the workforce. So experience really is everything. And, you know, sometimes you have to get that experience by just throwing yourself on the fire and figuring it out, right? So I’m really excited about having an attorney on the podcast today, because like you said, it’s really important for business owners to be able to protect themselves from legal disputes specifically with partnership and operating agreements. What are some common mistakes that you see with these types of agreements?
Ashley:
Unfortunately, with partnerships, I see so many mistakes because I think people don’t understand the law behind partnerships and the nature of partnerships. And so one of the biggest mistakes that I see is, first of all, you don’t have to have a written agreement to have a partnership, that is pretty standard partnership law. And so if you talk to a friend and you guys come up with this idea and you say, okay, let’s go into business together. And then something goes wrong down the road. And you don’t have a written agreement there still as a partnership, but it’s governed by your state statute. And frankly, the state statutes on partnerships are terrible when it comes to actually breaking up a partnership and you have to do exactly what the statute says to do or else you might find yourself in court. So I think the first mistake I see is either no agreement at all, realizing that you’ve created a legal partnership and then not having a written legal agreement.
But another mistake I see is that people will go into partnerships, but they won’t form an entity. They won’t form an LLC. And most of it is just cause they don’t understand what that can do. You know what the ramifications of that are? And so they’ll have this partnership, but there’s not an LLC or other type of entity that limits their liability and protects their individual personal assets. And so some people are really surprised when they come to me and they say, I want a partnership agreement. And I say, okay, well, let’s create your entity, create your LLC and create an operating agreement. And it’s the operating agreement that will serve as your partnership agreement. And so, you know, I see them maybe not including in that operating agreement, how they’re going to get out of this partnership, if something goes wrong, because if you go online and, I call it legal doom, but you get an operating agreement from you know, some kind of online source like that.
It’s not going to be customized. You have no idea what it says or what it doesn’t say, but I will tell you a lot of lawsuits that I was involved in as a litigator, when it comes to partnerships were based on poorly drafted operating agreements or partnership agreements, because there was no way for them to actually break up or divorce because partnership breakup is a lot like a divorce, only it can be a lot more expensive. And so when the operating agreement is drafted, you have to make sure that you’ve got certain provisions in there that are going to allow you guys to break up if you need to, or, you know, if someone becomes incapacitated or dies, you really need to know what your rights are. And then the other mistake that I see honestly, and this is probably the biggest one, is just going into business with the wrong person.
And that’s not legal advice. It’s kind of common sense. But I do see family partnerships and friendships. Those tend to be the hardest on partnerships. And so usually the partnerships that lasts the longest are those where it’s not a family member or a friend, but I think it’s important to look for some red flags, like, does this person want to sign an agreement? If you’re going into business with someone who doesn’t want to sign an agreement, huge red flag run for the Hills. And then also what are their personal finances? Like what, what is their personal life like? I kind of like to say, do they have their stuff together? And, you know, if they do and you trust them, then it could be a good partnership.
Tanner:
You know, I think another important thing is just finding a partner that really complements your weaknesses. So, you know, maybe someone is better at the creative side or coming up with really good ideas, but maybe they’re not so organized. But balance it out, right? So if you go into a partnership, someone that’s really, really similar to you, you’re going to butt heads all the time.
Ashley:
Well, I’m glad you brought that up because last year before I left the firm, one of the biggest cases that I worked on was a partnership between two guys who were basically the same person and they were best friends, but basically the same person. And it was a partnership in the fitness industry. And so you had two guys who were really into fitness and health and who also had some big egos, and the funny thing is they really truly were like the same person. And they ended up having a major dispute, and they had come into my office for, you know, settlement conferences. One of the partners was just threatening to sue the other one the entire time. And it was really funny because it was like watching the same person argue with himself. And, you know, that partnership only lasted a year and ended up costing each of the partners hundreds of thousands of dollars when it came down to it. Hundreds of thousands of dollars because they were so similar that there was no complement there. It was a constant butting of heads, and it ended up just being a disaster in the end.
Tanner:
Well, I mean, yeah, I can definitely see that it can get super ugly and, you know, I think it depends on the business and who’s going into business together, but what are some of the necessary elements that need to be included in an operating agreement?
It’s really good to have an attorney draft the operating agreement for you because they’ll know what you need to include for your particular partnership.
Ashley:
Okay. So, like I said online legal sources won’t always include these provisions. And so it’s really good to have an attorney draft the operating agreement for you because they’ll know what you need to include for your particular partnership, but there are some general provisions that the operating agreement should have. And the one thing you want to consider is, is this going to be a 50/50 partnership? And frankly, I’m going to put it out there. I don’t like 50/50 partnerships because a lot of times you have a deadlock in decision-making. If you want to do a 50/50 distribution in your partnership, there are ways that you can draft your operating agreement. So it can be, I get 50% of the distributions, you get 50 of the distributions, but when it comes to decision-making, I’m 51, you’re 49, or we can be 50/50.
But if we come to some kind of deadlock, we have a third party that we designate to come in. That’s, you know, an unbiased third party to make a decision that can be really cumbersome. And so what some people do is they will give somebody a 2% interest, a membership interest in the company and the owner, and that person is essentially the decision maker when there is a deadlock. And so you have to make sure that you address your membership interest percentages and how that’s going to affect your decision-making down the road. If you have some kind of deadlock and, and you will, if you have a partnership, there are going to be things that you’re not necessarily going to agree on. So you have to put in the agreement how you’re going to deal with that down the road. The other thing is you need a buyout provision, if this partnership ends up not working for us, how are we going to get out of it?
And this can be customized. It doesn’t have to be like the state, each state has an LLC statute. And if your operating agreement doesn’t address how you’re going to get out of your LLC, then you have to follow the statute. And that tends to be really problematic because essentially for most states, what it means is you have to get the company appraised and then you buy out the partner for whatever the company appraises for, you know, based on their membership interest. And I think that’s pretty standard, but it doesn’t have to be that way. It could be a lump sum. You know, you could have a partnership agreement where, hey, if this doesn’t work within the first couple years, then the one partner just has to pay the other partner $50,000. And so you’re not going to find that in these boiler plate, online operating agreements. The other thing you need is what the members can or can’t do, and you know, what the partners can or can’t do.
And then if you’re going to have an LLC, is it going to be member managed? And the thing about that is you can actually have a third-party manager that’s not a member of the LLC actually manage the LLC, or one of the members, one of the partners can be the manager or both partners can be the manager, but it’s important to understand that at the very outset, because in most states, when you create your LLC, you have to state whether it’s going to be member managed or manager managed. So it’s important to understand how you’re going to deal with that down the road. And then finally, you always need some type of provision that talks about what’s going to happen. If you, if either one of you becomes incapacitated or dies because some state statutes will say, okay, member one dies and their children can either choose to be bought out based on the membership and interest, or they can come and be members of the LLC. And then all of a sudden you’re dealing with your partner’s kids who are rotten and horrible, and you don’t like them, and you have to deal with that. So it’s really, really important to clarify that in the operating agreement.
Tanner:
Yeah, that that’s really good to know. I had no idea what the statute was on that. Let me ask you this, Ashley, if you don’t clarify who makes the decisions, if you identify a manager of the LLC, do they automatically become the decision maker?
Ashley:
Not necessarily, but it has to be in your agreement. So generally when I draft an operating agreement, I’ll say, here are the manager’s duties and responsibilities. However, when it comes to decision-making and voting, the partners have, you know, X amount and, you know, they have a 51% vote and a 49% vote or 50/50, but if there’s a deadlock, then the manager can come in and help alleviate that deadlock. So it really depends on what your agreement says, but if your agreement doesn’t say, then it depends on what your state statute says. And like I said, every state statute might be a little bit different.
Tanner:
Okay. That’s great to know. So another thing I’m curious about is have you ever seen a very one-sided operating agreement? Maybe one of the partners just uses their attorney and they favor themselves.
Ashley:
Absolutely. And a lot of this can be strategic and it might depend on the percentage of interest that one of the partners holds. And so you know, frankly, if I have a client and he owns 90% of the membership interests, but he has these minority members who might own like 3% each, or something like that. But in that case, it’s probably going to be skewed a lot toward the person who owns the 90%, you know, there’s going to be a preferred interest. So there are provisions that you can place in an operating agreement that, that are preferred distributions and preferred interest. And, if you don’t want that in your agreement or you do, you’ve got to make sure that that’s addressed, but generally in a partnership where it’s close to 50/50, most of the time, the decisions can be made based on the percentage of membership interest that the partner has.
And so if that’s how you want it drafted generally the best way to address that is to have a member managed LLC rather than a manager managed LLC. Because if you have a manager managed LLC, and your manager duties aren’t clearly outlined, then yes, that manager is going to have a lot of authority. And, I liked that you pointed out, you know, one of the partners has an attorney and that attorney drafts it. It’s really important as a partnership. You could have one attorney for your entity, your LLC, and say, hey, can you create this agreement for us? But then that attorney represents the company as a whole and has to serve the best interests of both partners. You could also say, go to an attorney and say, I’m a partner in this. Can you review this for me? And let me know if there are any red flags that pertain to me and the other partner should have his or her own attorney as well. And that’s the best way to do it because then you have two unbiased attorneys that can let you know what your risks might be.
Tanner:
Yeah. That’s a really good point. You know, it’s super important to protect yourself. A couple of hundred bucks having someone just review it, at least that gives you peace of mind, right? I mean, if a few hundred dollars now is a lot better than six figures later. Right?
It will definitely cost you not having well drafted agreement. Spending the thousand dollars at the outset could save you literally hundreds of thousands of dollars.
Ashley:
And I tell my clients that all the time, and maybe I have a skewed perspective because I was a litigation attorney, but I don’t think people understand how much litigation costs and it’s, you know, every time, even when I have clients that won their case in litigation, they didn’t walk away feeling like winners because they had paid their attorney $60,000 to fight this. And maybe they got $75,000 and they walk away with a $15 judgment. And then you find out that the person you just sued is insolvent and you can’t collect it anyway. And I mean, that happens a lot. That’s why I don’t love it. I do think it’s necessary in some cases, but I think if you have a well-drafted agreement, then you’re going to avoid that, but it will definitely cost you not having well drafted agreement. Spending the thousand dollars at the outset could save you literally hundreds of thousands of dollars.
Tanner:
Yeah. And that’s a very good point. So what are some other legal documents that entrepreneurs maybe don’t really think about that they really need to have in place? Not necessarily when they’re forming their business, but maybe just conducting business.
Ashley:
Yeah. So there are a number of legal documents that you should always have. You know, obviously some kind of operating agreement, even if you, as an entrepreneur are the only member of your LLC, or you’re the only shareholder of your corporation, you need to have some kind of organizational document that can protect you down the road as well. But it also lets people know what you want done with your interest, if something were to happen to you. And so always, always have some type of organizational document, even if you’re a single member LLC, or you’re the only shareholder of your corporation and have contracts with your clients, your vendors, your affiliates, make sure everything is in writing. I work with a lot of creative entrepreneurs and a lot of them will fail to do like image release, you know, image use releases and things like that. You have to have it all in writing. And what I loved about coming on your podcast, because I have a lot of clients who do podcasts and you sent me a podcast agreement and, and I actually was really excited, I was like this guy knows what he’s doing, making sure that every podcast guest that comes on signs an agreement. So they can’t later come back and say, hey, I own this. I have ownership rights to this. And so the job, like you’re definitely doing what you need to do.
And the other thing is, there are some documents that people don’t really consider. And some of that has to do with the legal language on your website. And so you need to have a privacy policy on your website. The law is your privacy policy has to be very clear and people have to understand it and you have to have disclaimers and you have to have terms of use or terms and conditions. And some people just kind of gloss over that. And either don’t include it on their website or they’ll copy and paste something from the internet that’s not even applicable. And you would be surprised at how that can come back to bite you down the road. So, make sure that you have the proper legal language on your website.
And then the other thing that a lot of entrepreneurs don’t consider is the protection of their intellectual property. You know, branding is really big right now. We’re in this global market where we’re online and you want to own your brand. If you don’t own your brand then you are exposing yourself to having to rebrand down the road or being sued for infringement. So another thing that I do for entrepreneurs is registered trademarks, or at least essentially do a search to ensure that they’re not infringing on someone’s trademarks because I had a client two years ago that had this brand for almost 10 years. And she had been doing business under this brand. She had merge merchandise under this brand and she received a cease and desist letter after 10 years of someone who had just been using the brand to, before she did and had registered the trademark and had been using it. And, granted, she was more successful with this brand name than this other person was. But I think what happened is this other person said, oh, she’s really successful. I don’t want her to keep using this brand name. There’s a likelihood of confusion here. And my client had to completely rebrand her entire business. And I mean, it costs her thousands of dollars to do that. So a lot of entrepreneurs don’t consider that, but they should.
Tanner:
Yeah. I mean, as a branding agency, branding is insanely expensive and, you know, creating a separate strategy for a new brand is a beast as well. You know, something actually happened similarly to that with Amazon. So there was a small company that was called Amazon and amazon.co, and amazon.com registered the trademark, so they screwed them out of it.
Ashley:
Yeah. And the rule in the United States is that the first person to use the trademark in commerce wins. However, so let’s say little, little Amazon, we’ll call it the little Amazon. They were probably the first to use it in commerce. And then big Amazon went and registered the trademark. And so technically little Amazon would have probably had the rights, but, I mean, who wants to go up against big Amazon in a lawsuit? You’re not going to win. It’s going to cost you hundreds of thousands of dollars. Is it worth it? And so while little Amazon might’ve actually had the rights, it would have cost them too much to fight it. And there’s a similar situation right now happening with the band that used to be Lady Antebellum, but now they want it to rebrand to Lady A and there was already a Lady A, and there’s this big fight between them right now. And because of a trademark issue. So it’s, it’s important at the outset. If you love your brand, then protect it and actually own it.
Tanner:
Yeah. I mean it costs what 350 bucks for a trademark.
Ashley:
Yeah. Well, if you do it yourself, it does. I find that most people that do it themselves end up getting rejected because they don’t understand the nuances. And so if you just do it yourself, then you’re going to pay the USPTO around $350, or it could cost more if they end up rejecting it and you have to fight it. Or you can pay an attorney a little bit more. And then if there’s a rejection, the attorney can handle that as well. So it depends on how confident you are with doing it yourself.
Tanner:
That makes a lot of sense. So what’s the biggest legal mistake that you think entrepreneurs make?
Not hiring a lawyer at the outset is probably the biggest mistake.
Ashley:
I think the biggest legal mistake, and maybe this is a little self-serving because I’m a lawyer, but I see that entrepreneurs don’t worry enough about legal ramifications. You know, they’re good at what they do. They’re good business people, but they forget about the legal ramifications. And then generally when they come to me, it’s too late because they haven’t done the work at the outset to make sure that legal security is in place. So not hiring a lawyer at the outset is probably the biggest mistake. I know it’s expensive, I get it, but it will be worth the money that you spend to save thousands of dollars down the road in some type of litigation.
Tanner:
That’s great advice. Absolutely. I want to thank you for taking the time to do this interview. Is there anything that I have not asked you that you think might benefit the audience?
Ashley:
No, but I would love to come back sometime. I think what you’re doing is great and, and like I said, you’re clearly a good business owner with good legal and business sense. So I appreciate it.
Tanner:
Thank you so much for the compliment, Ashley. What’s a great way for anyone listening to get in contact with you?
Ashley:
So my website is AGSlawfirm.com. I can also be found on Instagram at Ashley Garbe Smith. And then I also have an AGS Law Firm Instagram handle, and then on Facebook at Ashley Garbe Smith.
Tanner:
Awesome. Well, we’ll be sure to link those up in the show notes again. Thank you, Ashley.
Ashley:
Thank you.