Protect yourself, your partners, and your business—with a clearly defined operating agreement.
By Laurie Hileman
Hollywood dramatized Facebook’s early days in the 2010 hit film, The Social Network, which zeroed in on lawsuits brought by the Winklevoss brothers—who claimed that Zuckerberg, the then Harvard sophomore, stole their idea after they hired him to do a similar project—and Zuckerberg’s friend, Eduardo Saverin, who supplied initial seed money.
Although the nitty-gritty details of Facebook’s beginnings are murky, one business lesson is crystal clear: Written operating (or partnership) agreements are really, really important.
“Disputes about decisions and the direction of the business can become a problem between potential partners,” says Michael Formsma, a CPA with Boge, Wybenga & Bradley, PC. Ideas conflict. Feelings get hurt. Ambitions change.
“An operating agreement will settle any disputes, as it establishes ownership and identifies the ultimate decision-maker,” says Formsma.
If you have more than one investor, or others that play a critical role in your business, an operating agreement can protect you, your partners, and your business down the road. Here’s what you need to know.
OPERATING AGREEMENTS DEFINED
“When you’re talking about having a partnership or anything where several people are trying to work together, it’s good to put something down on paper so from the start everyone agrees who is responsible for what,” says Formsma.
Depending on the legal entity you select for your business, the shareholder agreement (for a corporation), operating agreement (for an LLC), or partnership agreement serves as a governing document that outlines the rules by which members and managers operate.
Agreements are required in some states. And while not required by the State of Michigan, the state does consider them “highly advisable” according to its Guide to Starting and Operating a Small Business. It describes operating agreements as “the basis on which you establish consistency and understanding about how meetings are conducted, how the company will be managed and decisions made, duties of members, what contributions are required from members, how profits and losses will be calculated, limitations of liability and protection of members, and how members might be added, terminated, or exit.”
In short, operating agreements aim to answer all of the “what ifs.”
What if one partner wants out? What if founders can’t agree on an important business decision? What if a member dies? How are the profits divided among shareholders? (Okay, not a “what if,” but you get the idea.)
SWEAT THE EQUITY – AND DECISION MAKING POWER
Unless you’re a cash-rich, business-savvy, big-picture thinker with lots of time on your hands, chances are at some point you’re going to need to bring in partners to help along your business. Or maybe you’re already established and want to incentivize a key employee with a share of the pie.
One of the most important things an operating agreement does is clearly define the ownership percentages and final decision-making power in the business.
Without clear definitions, you may find yourself in a never-ending cycle of management and financial misunderstandings based on verbal agreements made long ago. Even worse, you may be relegated to following generic state rules that do not consider your unique circumstances, which may lead to unfair profit splits, infighting, and other messes.
“We see a lot of relationships, partnerships, and companies go bad because they haven’t outlined all of the rules and responsibilities in association with the equity,” says Erin Strang, president and CEO of CMURC.
And the most important responsibility that comes up, adds Formsma, “is who gets the final decision.”
“If you have four people and each owns 25 percent, and two think one thing and two think another, it’s hard to move forward and get anywhere,” he says. And, while some might argue everyone with equal share should have equal say, “at the end of the day, somebody has to be given the ability to make a decision so the company can keep moving forward,” says Formsma.
Timing is critical. “You need to talk through and have those conversations on Day 1, not a year in when you get in to an argument,” notes Strang. “And not when money is on the table.”
PUTTING IT ON PAPER
Before pen is ever put to paper, Strang recommends getting a good handle on everyone’s individual goals and what vision you all have for the company. Once these are understood, you’re ready to draft an operating agreement.
Strang and Formsma note that because operating agreements are legally binding, a professional one drafted and reviewed by an attorney is best.
According to Strang, hammering out the details of an operating agreement can be “hard conversations to have but go a long way in solidifying relationships.” These are relationships that should strengthen and propel your business forward, not cripple or end the business.
While not having a written operating or partnership agreement puts you and your company at unnecessary risk—just ask the Winklevoss Brothers and Eduardo Saverin—early missteps don’t always spell automatic doom for a solid business venture.
“The great thing about going in to business is you can do whatever you want—there’s no one way to do it. Finding people who share your vision and wish to see the business succeed is ultimately what is most important,” says Strang.