Yes, YOU! You Need an LLC Operating Agreement!

9/1/2020

Just like you shouldn’t do business on a handshake, you shouldn’t operate your business on a handshake either. But too many entrepreneurs regularly go into business without any formal documentation. If you have business partners, so-called “silent” investors, or took money from friends and family, I cannot stress enough how important it is to have the terms of these partnerships documented in a formal written agreement. Otherwise, it’s just a dispute waiting to happen.

If I had a dollar for every time a client or prospective client told me that their business partner/best friend/family member would never sue them, I’d be writing this article from a beach in the Caribbean right now.

There are a few critical questions that every company operating agreement* should answer.

Who owns the business?

Believe it or not, disputes arise between business partners all the time who cannot even agree on who owns a share of the business (or how much of a share). A good LLC operating agreement not only sets forth who the members (or owners) are, but even what percentage of the business they own, and what they contributed in exchange for their interest in the business.

These disputes over ownership often come down to Partner A contributed the cash to start or purchase the business, and Partner B “just” contributed services to get the business up and running. When the relationship between A and B deteriorates, it’s not unusual for Partner A to suddenly claim that they are the sole owner of the business because Partner B never put any money into it.

Legally, Partner A is quite wrong. Contributions to an LLC can be in the form of cash, property, services, a promissory note, or any other binding obligation (including any combination of these). But Partner B is still losing sleep fighting for a business that they’ve worked so hard to build that Partner A now wants to cut them out of.

How can the company raise additional capital?

If the LLC ever needs to raise additional cash to get the business through a challenging time (and 2020 has been a challenging time for many small businesses), how will that additional money be treated? In some cases, the capital comes from a business partner who can afford to contribute more money or take on more risk. Before the business even gets to this point, the operating agreement should address whether additional cash from one of the members will be treated as a loan, or whether that member will effectively be purchasing an additional ownership interest in the business. This can skew any carefully considered ownership percentages or even change who the majority owner is. (And if the additional capital is a loan, then a separate promissory note detailing the terms of the loan and its repayment should be drafted.)

In other instances, the additional capital comes from an outsider, often a friend or family member. Not only does the company need to document whether the capital is a loan or an equity investment, but the operating agreement should address whether new members are permitted and what their rights are as members (at least to the extent those rights can be limited under the Ohio Revised Code). Regardless of what the company decides to call the outside capital, the LLC also needs to consider the legal implications of both state and federal securities laws. This will likely require the preparation of extra documents, i.e. promissory notes or investment disclosures and agreements.

How are management decisions to be made?

You and your business partners are human. You are never going to agree on every aspect of running the business. Will certain partners be in charge of aspects of the business that fit within their unique skill set? What kinds of decisions should require a vote? What happens in the event of a tie?

Even nitty gritty details like who has access to the company bank account(s) should be determined long before a dispute arises. (Legally, each business partner is entitled to access information about the state of affairs of the business, including the books and records of the business. But this does not mean that everyone should have a company debit card and check writing authority.)

What happens when someone wants out?

Eventually, owners will wish to retire, move on to new business ventures, or, worst case scenario, get so fed up with each other, that it’s time to part ways. Planning for this scenario is perhaps the most complicated part of drafting an operating agreement, but it’s still easier to figure out while everyone likes and trusts (or at least respects) one another than after a dispute has arisen.

The company operating agreement should address common buy-sell scenarios and explain in detail the terms of any sale of membership interests in the company. Buy-sell provisions could easily be a whole series of blog posts, but you should at least consider:

How will the members agree on a value for the company? What is Partner C’s share of the company worth?
Will the agreed upon purchase price be paid at once (and how will the company or remaining partners afford to do so), or will the buy-out take place over a period of time?
Under what circumstances can or should a partner be forced out? (If any of the partners are also employees of the company, what happens to their ownership interest if that partner-employee has to be fired from their employment?)
Can partners leave their share of the business to their heirs? (In other words, do you want to inherit your partner’s spouse or children as business partners?)
Can partners buy each other out (and potentially become majority owners in the process), or should an offer to sell an interest in the company be first made to the company itself (to keep the remaining partners on an even playing field)?
What happens if one of your business partners gets divorced?
What are the tax implications of any potential sale?

What if we can’t agree, even with a written agreement?

Finally, plan for dispute resolution. If nothing else, the operating agreement should set the ground rules for resolving any disputes, preferably well before everyone ends up in court. Mandatory mediation can save the members thousands of dollars in legal fees and hundreds of hours away from the business (assuming, of course, that everyone is capable of setting aside their emotional baggage and getting down to the business of going their separate ways).

Failing a peaceful resolution, the operating agreement should dictate what court will be used for any litigation among the business partners. And it should provide that the loser will pay the winner’s legal fees. Contrary to popular belief, without this provision, everyone will almost certainly pay their own legal fees, and in business partner divorce type cases, the only real winners are often the attorneys on both sides of the dispute.

Obviously, an operating agreement is only useful if everyone signs it and actually follows it. But so many things can and will eventually go wrong if your LLC doesn’t have one. If you have business partners and don’t have a written agreement, stop putting it off and schedule today.

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*With other entity types, the title of the agreement may change, but the basic idea is still the same.

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