Two Important Steps for Creating Business Operating Agreements
Two friends go into business together...sound familiar?
Andrea and Susan were old friends who decided to start a small business together in Montana. For them the process of setting up their business was fairly simple - they found a great downtown location for their little gift shop, each invested a small amount of their own money to purchase inventory, and then they were open for business.
Initially they did not form a separate business entity, but within a few months of opening they decided to form a limited liability company, or an “LLC.” Andrea found the “Articles of Organization” form, and filed it with the Montana Secretary of State.
Over the coming months, both owners would use personal funds to help purchase inventory, in amounts they agreed upon, but they never formalized any agreement with a business lawyer regarding using personal funds for the business.
After several years of being in business, Susan decided she wanted to spend more time traveling and no longer wanted to be involved in the business.
At that point in time the gift shop had become quite successful and Susan believed her interest in the company had become very valuable. With that in mind, Susan approached Andrea to let her know her intentions for leaving the company and suggested Andrea buy her out of the business.
However, the amount suggested by Susan was shockingly high to Andrea. According to Andrea, Susan was only entitled to her initial investment, which was less than one-third the amount proposed by Susan.
Andrea suggested a lower price and unfortunately the two spent the next year arguing over the value of Susan’s interest.
This situation is all too common for small businesses. The owners file a form to become a separate entity such as an LLC or corporation in an effort to protect themselves from personal liability, but fail to actually follow the formalities of a separate entity or execute an operating agreement.
As the best business lawyers will attest, the operating agreement is key in determining the value of the business, how individual owners may join or withdraw from the business, and what happens to an owner’s interest in the event of their untimely death, bankruptcy or other life event.
Make your relationship formal
First, observance of LLC or corporate formalities is an important factor in determining whether it will actually be treated as a separate entity.
If the LLC or corporation is not treated as a separate entity, then the members or shareholders may be held personally liable for the debts and obligations of the company.
As a business lawyer, here are some of my best tips for how to keep business and personal matters separate:
Refrain from co-mingling business funds or accounts with personal funds. If you are placing personal funds in the business, make sure it is accounted for as a capital contribution, a loan or a reimbursed expense.
Always make clear when you are acting on behalf of the business, rather than acting in a personal capacity. This may include signing documents in a representative capacity or clarifying your role in a business meeting.
Do not use funds owned by the business to pay personal debts and obligations. Personal obligations should not be paid directly from business accounts. If you need to make a personal payment, pay yourself first as a member or shareholder of the business, then make a payment from your personal account.
Maintain written documentation of actions of Members, Shareholders, Directors or Officers. This includes maintaining minutes of your annual meeting and any special meetings, or written consents, signed by all owners.
Operating agreements are a MUST
Do not skip this step when going into partnership with anyone.
An operating agreement is the document used by the owners or “members” of an LLC. A shareholder agreement is the document used by the owners or “shareholders” of a corporation.
For discussion purposes the term “operating agreement” is used here to generally discuss internal documents for the operation of various business types, but a different term may be used for a different type of entity.
An operating agreement is a contract between the members of the LLC and the LLC as a separate entity. It sets out all of the internal terms for the operation of the LLC. These terms may include valuation, distribution of profits and losses, and the withdrawal or addition of a new member.
While an operating agreement may be drafted by a business lawyer, it is important the members or owners of the business have a discussion as to the important points of the operating agreement.
This ensures everyone is on the same page and has discussed these issues from the beginning of the business, rather than trying to figure out these issues in a disagreement or other unknown circumstance.
Some important issues I have my clients discuss in the creation of an operating agreement include:
What limitations to place on transfers of ownership? Some options include: no transfer without consent of all owners; right of first refusal of company and/or members; limitations on forced buy-outs; or right to remove owners for certain unlawful or unethical actions.
How to fund a buy-out of an owner? Consider such issues as allowance for installment payments, use of life insurance, or loans.
How to calculate the value of an ownership interest in the business? Will the value simply be book value, or assets minus liabilities of the company? Or do you want to use a different formula? Do you want to set a price in advance?
What happens in the event of unforeseen life circumstances? Consider what happens to an owner’s interest in the business when that individual owner retires or wants to withdraw from the business, becomes disabled, gets a divorce or files for bankruptcy.
Obviously these are just some of the discussion points to consider when creating an operating agreement. The best business attorney will advise you on options for your particular business.
However, it is important the business owners discuss these issues prior to starting a business, rather than wait until after a dispute arises, like Andrea and Susan.
If only Andrea and Susan had taken some extra time to create an operating agreement when they started their business, they could have spent less time and money arguing back and forth over the value.
Instead, Andrea could have easily pivoted her role to a sole-proprietor or found a new business partner, and Susan could have been released with buyout money to travel the world.
By taking the time to discuss a potential buy-out in the beginning of their business these women could have saved themselves significant time and money in the long-run.