Partnerships are formed in the expectation of building a successful business.
However, sometimes businesses fail.
That’s when having an operating agree
Going into a sideline business with a client could be a recipe for disaster, particularly if the venture peters out.
So when an accounting and tax advisor in Memphis, TN, and a trained chef signed an operating agreement when they formed an LLC partnership to open a barbecue restaurant.
It’s a good thing they did. When the restaurant failed to make money after three years, the partners closed it and, as their agreement stipulated, shared the loss. "We could have had a falling out, but we stood by our operating agreement, and it preserved the relationship,” says according to the accountant. Equally as important, they maintained their professional relationship despite the failure.
Unfortunately, too many business owners skip the important step of executing an operating agreement when they form a limited liability company to invest in and operate a business. Only a handful of states require LLC “members” – the legal term used when referring to partners – to have an operating agreement, “but whether the document is mandatory or not, it is essential. We never let a client walk out of our office without one,” explains Stephen R. Levy, Esq., a partner at Kurzman Eisenberg Corbin & Lever, LLP in White Plains, NY.
An operating agreement is a separate document that defines the contributions, voting rights, interest, and responsibilities of all members of a partnership. It provides answers to tough questions, such as what happens to the original members’ interest if another partner joins the business? Or how much time is the member/manager required to devote to the business, and should that member/manager be paid a fee or salary? And perhaps most importantly, what happens if the business is shut down?
Most entrepreneurs don’t like to contemplate that their partnership will hit some bumps along the road, but it’s better to deal with the risks when you are on good terms. “It’s like doing a will,” Mr. Levy says. "You have to address some hard issues. But when a question arises or the business is dissolved, an operating agreement provides a plan to follow and minimize the conflict among LLC members."
Adds Fred D. Weinstein, Esq., a partner and corporate law litigator at Kurzman Eisenberg Corbin & Lever, LLP: "Operating agreements help you reduce the risk of a lot of litigation down the road."
In the case of thes barbecue restaurant, the members did not contribute equal amounts of money and time to a business. The operating agreement took this into account when it set a value on their contributions. For example, the chef says he put in cash and sweat-equity and managed the business, while his partner invested just cash. In the operating agreement, they agreed to each assume 50% of the business’ liabilities if it failed.
But even when businesses thrive, agreements are still important. They serve as operations manuals, specifying who has check-signing power, how frequently partners must meet, and how decisions are made and by whom. The document should spell out which business decisions require a vote of the full membership. In addition, the document should address how much weight each member’s vote has. Another significant consideration is what happens if someone wants to buy the business? Do all members have to agree to sell the entity, or can one person veto the sale? How will the price be set and the proceeds distributed?
The operating agreement also should address what happens if one member becomes incapacitated or dies. “Without an operating agreement, there is no mechanism for making an easy transition to new ownership,” notes Levy. “If your partner dies, suddenly you find you are in business with your partner’s heirs. That probably wasn’t part of your game plan.”
What’s in an operating agreement
Levy says operating agreements can be simple or complex, but it is a mistake to use a template and draft it on your own. “This may be your first or second business, and you may have no idea of what could come up. A good corporate law attorney will have worked with hundreds of businesses, and can anticipate the risks you’ll face,” he explains, adding that: “Experienced attorneys should also represent each member to make sure that the agreement is fair to all parties.”
Operating agreements typically address these issues, although the agreement can be as detailed as necessary:
- Each member’s role and interest in the enterprise
- Each member’s contribution
- How revenue will be distributed
- Who will manage the enterprise, and a description of the manager’s responsibilities
- Each member’s voting rights
- How members can exit the LLC
- Under what circumstances a member can be removed
- Provisions in the event of a member’s death or incapacitation
Starting an LLC with someone else isn’t easy, but preparing an operating agreement will clarify important issues early on, and make it easier to operate the business in the future.