The Fine Print
You’ve decided to start a business. And you know from your research that a limited liability company is probably the right legal structure for your company. Now what?
The next step is to create an operating agreement, which is the company’s manual for handling key financial and functional issues that will arise over the company’s life. Do it right and you will have prevented disputes and paved a smooth runway for the company. Do it wrong and you’ll have pockmarked your runway with potholes that will trip you into drama in the months and years to come.
Fortunately, thoughtful planning at the beginning can reduce nasty surprises during the middle and end. Below are eight areas in particular that you will want to take special care with when you start your company.
First, the operating agreement should spell out ownership, especially if the company has multiple owners (known as “members” in the LLC context). In some cases, this will be easy. For example, if two partners start a business, invest the same amount of money, and then work full-time for the business, the partners will normally agree to an even split. But what if a business has three owners, one who came up with the idea, another who will do most of the work, and a third that put up the money? Unsurprisingly, each of them will value their contributions differently. And that can lead to ruffled feathers. Best to hash out the value of those contributions at the start.
Second, the operating agreement needs to say how the company will be managed. Will the members do it? If so, the LLC is known as member-managed. Will the company appoint someone else to do it? If so, the LLC is known as manager-managed. And regardless of who manages the company’s day-to-day affairs, the operating agreement also needs to list what subjects the owners alone may decide—topics like selling major assets, amending the operating agreement, dissolving the company, and other major events.
Third, company’s operating agreement should discuss how to handle profits and losses, especially if each owner has not invested equally in the company. Without that information, you will have to hope that the default legal rules match your intentions, which is not guaranteed. For instance, in the example above where the two owners put in the same financial and sweat equity, the default rules will produce a reasonable result. But in the example where the three owners have very different roles, the default rules will yield a surprising outcome.
Fourth, many companies need an infusion of extra cash at some point. These moments are often a flashpoint. Maybe the owners disagree on whether to pump money into the company. Or maybe one of the owners doesn’t have the money to do so at that moment. Or maybe one owner is willing to give the company a loan but the ownership cannot agree on the terms of that loan. Whatever the reason, raising revenue is a breeding ground for disputes, so it’s best to decide how the company will get capital far in advance of when the company will actually need to do so.
Fifth, eventually one or more of the owners will want to cash out their chips and leave the business. How should that work? Perhaps the other owners will get a period of time to buy out the departing owner or a deadline to match an outside party’s offer. Or perhaps something else. But whatever that exit might look like, it’s generally a good idea for the operating agreement to describe the procedure for whether and how an owner can sell their stake in the business.
Sixth, no business lives forever. Some live until their owners or the government dissolve them. Others survive until their purpose ends—such as a company created to buy and later sell a piece of land. And other companies have explicit time limits such as an investment fund, which generally manages its investors’ funds for a set period of time. No matter the anticipated expiration date of a company, every operating agreement should state the rules for pulling the plug and how to handle the aftermath such as winding down the business, selling its assets, and then distributing money to creditors and owners.
Seventh, while it would be nice to live in a world where all disagreements can be resolved amicably, we don’t live in that world. And, so, the operating agreement should say how intractable disputes are handled. Often the best choice will be an arbitration clause that requires a quick and confidential answer. But if you want the default option to be a slow, messy, and public dispute in the court system, then by all means, omit how to handle disputes from your operating agreement.
Finally, one of the chief reasons for starting an LLC is for its limited liability. To maximize that protection, make sure that your operating agreement includes words to the effect that the owners’ liability is limited to the money they actually invested and that creditors do not have the right to become owners, manage the company, or receive any money except pursuant to a charging order and, even then, only when the company voluntarily issues distributions.
If your operating agreement has these eight provisions, good job. You have eliminated a myriad of problems before they had a chance to take root. If your operating agreement overlooks some of these topics, it’s time to update it.