January 29

When Does Your Company Need an Operating Agreement?

Partnership Agreements, Operating Agreements, and other Corporate Governance Documents

Clients often call and state very matter of factly, “We’re starting a company and need an operating agreement for our LLC.” Clients also often say, “I’m having a disagreement with my partners and we need an operating agreement to resolve them.” While conventional wisdom would indicate it is never too early to get an agreement between business owners in place, it is not always necessary. Businesses that are well funded and that can afford to put the time and money into a thorough agreement should do so from the outset to avoid issues down the road. However, many new businesses have limited budgets and more importantly, are not turning any revenue.

One situation I frequently see is a few people come up with an idea for a business. They have a business plan, a basic structure in their minds of what the company should look like, but they have yet to launch the business nor do they have any revenue coming in. Depending on the nature of the business, an operating agreement may not be necessary at this point. While each individual situation is different and an attorney should always be consulted because there may be assets or other intellectual property put into the business, until there is a proof of concept, an operating agreement may be unnecessary. Operating agreements govern how business decisions get made, how money is spent and distributed, what to do if the company is failing, and who owns what percentage of the company. New businesses need to prioritize how they spend their money. Launching your business and gaining traction is more important than an operating agreement at the beginning.

With all that being said, it is a delicate balance. The business should be off and running with some promise but wait too long, and it may be too late to have an efficient negotiation of the operating agreement. My recommendation to clients is focus on making the business successful and the instant it that success starts to get recognized, is when you need an operating agreement. As I said earlier, this advice varies as in some cases partners may want an operating agreement from the outset depending on the various contributions of the partner. A partner who is contributing a valuable patent or other intellectual property, or who is contributing real property, or even a large sum of money should insist on an operating agreement before anything happens. However, businesses that are more conceptual than actual don’t need an agreement until the concept starts evolving into a reality. In other words, many companies don’t need an operating agreement when there is only smoke. They should devote their resources towards getting that fire started. However, the minute a spark is seen is when it is time to consult with an attorney and negotiate all of the material terms as to how to run the business. Do this too early, and you may spend money unnecessarily that could be better spent elsewhere. Wait too long and the company’s success may make negotiating the operating agreement much more difficult.

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