Operating Agreements

 [Published originally in 2015.]

CONGRATULATIONS! YOU AND YOUR FRIENDS HAVE DECIDED THAT THE TIME HAS COME. YOUR TRIO, AFTER A FEW CONVERSATIONS THAT BEGAN IN EARNEST, IS NOW SERIOUS ABOUT LIVING OUT YOUR DREAMS OF STARTING A NEW BUSINESS. YOU GUYS ARE READY TO GET TO WORK, AND ALONGSIDE THE MANY THINGS YOU AND YOUR FELLOW ENTREPRENEURS ARE WORKING ON – LIKE A BUSINESS PLAN, MARKETING PLAN, WEBSITE, AND SO – YOU ARE TOLD TO CONSIDER AN OPERATING AGREEMENT. “SO WHAT EXACTLY IS AN OPERATING AGREEMENT?” YOU ASK. “AND DO WE HONESTLY NEED THIS?”

The number of new entrepreneurs in America is rising. At the last count, in 2014, an estimated 14% of Americans started or were running new businesses. That is the largest percentage of the population ever tracked by the Global Entrepreneurship Monitor, a sixteen-year research collaborative between Babson College and the London Business School. To be sure, while the numbers might be impressive, little has changed about the level of risk many of these entrepreneurs face, particularly at the start of operations. In fact, according to the Small Business Administration, as many as one-third of new businesses with employees fail within the first two years, and then half of the remainder do not make it to five years. 

The reasons for such dim business survival rates can be pretty broad, but positioned squarely among the top of these reasons is the breakdown of leadership in new businesses. Often enough, new entrepreneurs are ill-prepared for the challenges that accompany the launch of a new business, and so, when the operations gain momentum, deficiencies in talent, infrastructure, leadership, and direction become glaring. With that, when two or more entrepreneurs have not formalized their roles or expectations, there is a greater likelihood that strife can occur. 

Therefore, in answer to the question: yes, an operating agreement is honestly needed. In fact, if a business plan is akin to the Bible of a new business - then consider an operating agreement its Magna Carta.

Some entrepreneurs may know an operating agreement by other names, i.e., a shareholders’ agreement, a founders’ agreement, or a partnership agreement. And yet so many others may not know it, at all, which is not entirely surprising. Nevertheless, essentially, these are all them same. An operating agreement, or many of these other variations, is written understandings among the founders of a new enterprise detailing thoroughly how that enterprise is formed and governing, quite precisely, how it is to be managed.  

Going into business with partners can naturally be a good thing for a new entrepreneur. In many cases, partners can bring with them, in exchange for equity in the new business, much needed capital and/or other resources like talent or professional networks. What’s more, when a partnership seems rightly in sync on the business’s purpose and plans, the added brainpower can cultivate fertile ground for new ideas.

Unfortunately, some partnerships do not go so well. Or, as Jake Duncan would say, “It can turn into a hell of a mess, real quick!” He would know. His partnership in a tool & dye shop ended on a very sour note, but that was not before the bad blood between him and partners led to allegations of thief, litigation, and the closure of the business. Like most failed partnership, the Duncan partnership did not plan holistically for its own success. They had never devised an operating agreement, because their nineteen year friendship, quote, “made it unnecessary”. Consequently, there was never a clear delineation in leadership, and no one knew who could make day-to-day decisions, who could spend what, or even how the business could be sold if or when one person wanted out.

To a new entrepreneur, it might not seem important in the outset, but such an agreement is vital to the governance of an enterprise. In fact, when dealing with two or more would-be members, partners, or shareholders of a new enterprise, it has become my common practice to stress the importance of a carefully-crafted operating agreement (or concise by-laws, in the case of a corporation), if only to govern the possible success of the enterprise. That’s because, once the money starts coming in, things change; people change. Even still, one might be amazed by the number of people who, after hearing the fullest explanation, profess to not see the point for such a document. Nevertheless, as has been the case with frightening consistency, only a matter of time passes before issues do surface that would have been easily mitigated by such an agreement. 

There are many intricate aspects to an effective operating agreement. It must cover in serious detail everything from monetary contributions to the management of operations and finances, from the roles of individual entrepreneurs to how decisions get made, from succession plans to matters pertaining to the budget, and more. Indeed, it can be an very absorbing document, but that is never a reason to shy away from its use. What’s more, while AxSA promotes the enactment of the operating agreement at the launch of any new business, this consultancy does point out that this document can be crafted at virtually any point in the business’s existence. So, yes, for even the more seasoned entrepreneur, there is a chance for hope.

While a comprehensive operating agreement has a plethora of components, it is important that each of them have at least five basic components, and it should consider these questions:

Regarding Equity
---Who are the members, partners, or shareholders of the enterprise, and what have they contributed to the enterprise?
---How is the equity of the enterprise divided among the stakeholders of the enterprise?
---What types of equity classes exist for stakeholders of the enterprise?

Regarding Roles, Agency & Conflicts
---Who are the managers of the enterprise? Who are its registered agents?
---Can all stakeholders conduct business in the name of the enterprise?
---If the stakeholders do play roles in the operations of the enterprise, what are those roles, and who has them?
---Are there adequate protections for the minority stakeholders if the managers or majority stakeholders knowingly commit misconduct in the name of the business?
---What constitutes a conflict of interest by any stakeholder or any employee of the enterprise?

Regarding Voting
---How many votes will each stakeholder possess?
---What constitutes a quorum?
---When will the shareholders meet to discuss new business?
---On what issues will a vote of 100% be required?
---How will dispute resolution be defined? 

Regarding Budgets & Finance
---How and when will the fiscal and project budgets for the enterprise be determined?
---Do managing stakeholders or registered agents have singular authority to make large purchases, or will such purchases be vetted through all stakeholders?
---Who will determine the compensation rates for new hires?
---What is the protocol for selecting and employing professional services?
---Will the enterprise be allowed to incur debt? If so, who has the authority to seek it, and who is expected to guarantee it?

Regarding the Exit of a Stakeholder
---Will the enterprise carry life insurance on any managing stakeholder?
---What is the succession plan for any stakeholder of the enterprise?
---If a stakeholder desires to leave the enterprise, will the other stakeholders have the right of first refusal? If so, what is the nature and timeline for the process?

Again, to be sure, there is a lot more to an operating agreement than these points, but think of these to be critical enough to consider here. Also, all of these might seem like burdensome considerations to entrepreneurs who would otherwise be eager to simply start their new businesses, but coming up with the right agreement is an essential part of the planning phase for your business. After all, while we might hope that every partnership can work out on its own, the truth is that many do not, and thankfully, documents like these can help keep order and protect the interests of stakeholders if relationships fail.