As a small business attorney, I am in a unique position to see all of the ways a business can, and does, go wrong. In their infancy, small businesses, are nearly always started by starry eyed entrepreneurs looking through rose colored glasses. Fresh with a new idea, new business owners are quick to go online and file for an LLC, thinking that is all they need to protect themselves. Often times, new partners rush to get to concept, and allow the “paperwork”, to float to the back burner. That is when trouble begins to brew.
When first starting a new business, new business partners often think they will always agree because both parties feel a kindred passion for the new venture. However, as time goes on parties can start to see how the business should progress differently, and disagreement starts to begin. Without an operating agreement, how will these decisions be made? This is one of the key reasons for an operating agreement, it gives you a baseline to govern the entity, and sets up how decisions will be made when there is disagreement.
For example, I recently had a client who came to me after a dispute with a partner. For the sake of clarity, this example, and to protect the confidentiality of clients, the names and the details here have been changed. Let’s call that client Charles. Charles had started a restaurant business (organized as an LLC) with a new partner, Barry, one he had never worked with before. Charles lived out of state and was going to handle the financial management of the restaurant while his partner managed the day to day operations. In the past Charles had always done deals on a handshake, and because he could trust his partners and they trusted him, they had always worked out. Barry, as it turned out was a less than perfect partner.
Barry was in charge of constructing the restaurants atmosphere in preparation for the initial operation (the “Build Out”), as well as coordinating the hiring of the initial staff. As it turned out, Barry was not good at keeping receipts or financial records, and by the time the restaurant was scheduled to open they were way over budget. In addition to this, issues with the Buildout were discovered causing the need for repair, causing additional expense.
Needless to say, this partner had to go. Charles had spent about half a million dollars into this venture, while Barry had just $45,000. Unfortunately, other than some sparse paperwork filed with state to set up the company, the pair had never taken the time to formalize everything in an operating agreement and had instead jumped into gear. This made it very difficult to determine, how the other would be removed, or even what their ownership interest was.
When all was said and done, we were able to assist Charles with this issue, but had there been a clear and easy procedure to handle such an event in an operating agreement, such conflict could have been completely avoided. And that’s not the only problem operating agreements help you solve.
This leaves us with the question, what should a good operating agreement include? Here are just a few of the things you want to make sure to include in your operating agreement:
How will the ownership be organized? Will one side own more then the other? Will there be more than one kind of owner? Is someone a “Silent Partner”?
Who is going to be responsible for managing the business? What aspects will each person control? How can a manager be removed or replaced? These are all things you will want to make sure to cover in your operating agreement. Making sure to spend time going over these procedures together, before anything happens can also help to stamp out conflict, if a change of management were to occur.
What kind of decisions will require a vote? Who will be allowed to vote and how much of a vote shall each of them be entitled to receive?
How are profits and losses going to work? Will some members or managers have a fixed payout or salary? It is important that your operating agreement covers how the money will flow in and out of the business.
Do you want to protect members from dilution in the event new members are admitted?
What are the rules on selling your interest in the business? Does the business have a right to buy back your interest at a fixed price should something happen? What happens if the other owner passes away or goes bankrupt? (You may also want to consider setting up a buy/sell agreement, which is funded by life insurance, but that is a topic for another day).
How and when will the business be dissolved? Who gets paid and in what order?
This is not an exhaustive list of everything that should be in an operating agreement, but it does give you a good idea of some of the things you need to consider when starting or running a business.
If you would like assistance in setting up your operating agreement, or if you have any other questions related to your small business, give us a call at 954-603-7603. We are here to help.