Key Provisions of an Effective Operating Agreement

Every limited liability company should have an operating agreement reflecting the understanding of the parties on how the business should be run.  In part 1 of this series, we examined some real-world business relationships pertaining to operating agreements. In this post, I’ll discuss some important provisions that an effective operating agreement should have to protect the business parties.

Most operating agreements have standard sections, but that doesn't mean that changes can’t be made. An operating agreement should not be viewed as a one-size-fits-all document. Each business is unique and these provisions should be clearly laid out to handle issues as they arise.

Here are some sections and key points that deserve special consideration when a business draws up an operating agreement.

• Capital and capital contributions — Subsequent contributions should only be an obligation if unanimously agreed upon by all the members.
• Allocations and distributions — The company should have the right to distribute cash and property to the members pro rata, based on the relative membership interests.
• Management — The managing member should have the power pursuant to the operating agreement to perform the following on a day-to-day basis: open and manage bank accounts, borrow funds or establish lines of credit up to $5,000, purchase insurance on company assets, enter into agreements with vendors, suppliers, and contractors, and perform other operational tasks and duties.

More substantial actions should require the approval of a majority percentage of the members. These can include: borrowing more than $5,000 or making any capital expenditure in excess of $5,000, commencing lawsuits or other legal proceedings, making a filing under the Bankruptcy Code, purchasing, leasing, or disposing of property—including real property—in excess of $5,000. Lastly, any action to dissolve the company would fall under a majority percentage of member participation as well.

Adding new members to the company (or altering the percentage ownership in the company) should require the unanimous approval by all members.

Withdrawal and transfers of membership interests — This should cover such issues as how a member may withdraw from the company prior to the winding down and dissolution of the company, such as if a 60-day prior notice should be given. Also, restrictions on transfer should be clearly laid out, and sale of membership interest details should be given so that adequate time requirements are made known to all members.

A very important provision you always want to include is what would happen in the event of a member’s death, or if a member gets divorced. Washington is a community property state, which means that a spouse has a 50% interest in every single dollar made by a spouse. In every business, a spouse automatically shares a 50% economic interest with the other spouse. So a divorce could significantly impact the business if provisions aren’t made.

I always recommend a clause that says in the event of disillusion of marriage, we’ll recognize that the divorcing spouse has a 50% interest that’s economic only. The divorcing parties agree to put a dollar figure on that interest and the non-member spouse is given 50% monetary value, but not membership in the company, so he or she would not be able to make any decisions pertaining to the business. 

Since each business is unique, your business may require special language to protect all members. If you are considering drafting an operating agreement for your business, contact us to set up a consultation. 

Protecting Your Business with an Operating Agreement

When forming a business partnership, it’s important for the parties to protect themselves with an operating agreement so that issues can be resolved in an orderly fashion.

This is part 1 of a 2-part series examining operating agreements. In this post, I’ll begin by looking at two real-world examples that illustrate why it’s crucial to create and abide by an operating agreement. In part 2, I’ll discuss some key provisions needed in a standard operating agreement.

The first case involves two people who had a 50-50 arrangement in a business they co-owned as an S-Corporation. The business was succeeding and everything was fine between the two sharehholders. However, as the months passed, one partner was doing far more work than the other. I was representing the active business partner, who was handling the operational and business side of things, while the other partner just wanted to collect a check from the monthly profits.

Understandably, the partner doing all of the work wanted to buy out the other partner, since she was collecting a check for doing nothing. Because the two didn't have an agreement, the non-active partner had been hiring accountants and lawyers to do things that my client didn't agree with. A considerable amount of time was spent answering his legal questions about what his partner could or couldn’t do, and what the legal ramifications of dissolving the corporation would be going forward. Unfortunately, the way they formed their corporation, evenly dividing everything, required a unanimous decision by both partners on every matter. Once they became adversarial, the only solution legally was to dissolve the partnership.

Having had an operational agreement in place in the beginning could have gone a long way to avoiding the problems that had arisen. Specifically addressing such important matters in the decision-making process is something I advise for any partnership looking to do business.

The alternative to seeking legal counsel in this situation might have been to hire a life coach or business coach. A lot of times, people seek me out for legal counsel, but the problems they have aren’t (yet) of the legal nature. This is a great solution when people are not getting along and need to find a way to resolve interpersonal conflicts. In other words, they think they've got a legal problem, but that’s not necessarily true. These coaches can talk you through decision-making and how to be happy in your business. Irene Leonard and her business, Coaching for Change, is someone I highly regard offering this service.

In the second case I encountered, another client thought ahead about decision-making. He and his partner drew up an operating agreement where a coin flip would be the deciding factor for disputed management decisions.

They had been working together for 15 years, and they were positive that they'd work together for more.  I pointed out that, while there may not be disagreements at this exact moment, they could arise years from now. For example, what if one wanted to move the location, but the other person didn’t? Neither wanted to decide who would have to make these kinds of decisions, so they entered into an agreement where they would have to flip a coin and abide by the outcome. The partnership has been working just fine the last three years, and if any issues arise, they will pick up a coin and toss it.

No matter what way a business decides to resolve issues, they should be in writing to protect all parties. Each business partnership is different, so if you feel you should have a formal arrangement drawn up, contact us to set up a meeting.