Source: Establishing the rules of engagement is one of the most critical steps in protecting the legacy of one’s business from potential risk. To set the tone of the law of the land for your new venture, you must have an effective operating agreement or company charter. This becomes the place of reference when it’s time to deal with a dispute between business partners. Samuel K. Burlum shares the importance of having an operating agreement. 

In the initial hustle and bustle of establishing a new small business venture, I have found that most small business owners overlook the importance of setting up rules and standards for their business to be governed by. Then later, because the rule of the law of the business was overlooked or never formally established, they are forced to face challenges that put the business at risk. I have seen several small businesses face serious consequences, including litigation from a business partner, employee disputes, relationships with vendors change, all because they did not have key agreements and elements in place.

Every business start-up enterprise has an opportunity to minimize further risk by establishing key agreements in the very beginning. It does not matter how well you know your business partner, or that your investor is a family member; when money and time is involved, each person has a set of expectations that may not be as clearly expressed as they should. Many issues and concerns can be addressed for business owner, investor(s), employees, vendors, and even third parties and clients, through a number of governing tools.

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Most small businesses are either a sole proprietorship or are a limited liability company. In these cases, a document known as an Operating Agreement, acts as the business’s decree on how many operational and executive decisions can be made, how profits and/or losses are distributed to business partners, or members of the LLC, and dissolution of the business. Some of the most effective Operating Agreements have provisions that address the following areas: assignment of managers (directors); recognition of the capital infusion by each member or business owner; allocation of the percentage of ownership to each owner-investor; establishment of rules on how to treat profits/losses and the treatment of cash flows; members meetings, rights, and voting procedures; accountability; transparency; member-manager compensation for their services provided within operating the business; and additional provisions on how to handle a member or business partner’s request to leave or exit the business. These are key areas of concerns that can make or break a business.

Having an effective Operating Agreement, will help mediate and mitigate disagreements between business partners. Each owner or partner, and/or member must agree to each term and condition within the Operating Agreement as well as abide by upholding the standards of conduct spelled out in this type of document. In essence, the Operating Agreement becomes the law of the land for that business entity.

Once an Operating Agreement is signed by all owners, managers and members of that business, it should be notarized and filed with the business entity’s state of jurisdiction, with the Office of the Secretary of State. In the event of a dispute, the rule of law for the business can be recognized where the issues may result in having to litigate in Court.

The devil is in the detail of an Operating Agreement. A business partner (or partners) who is not fully honest about their long-term intentions, or by counsel of each business partner can poison a business. To avoid or prevent this, there are a few critical areas of an Operating Agreement any business owner should take notice of. When it comes to who can change the terms and conditions of an operating agreement, usually what is standard is the party that holds 51% stake of the business entity or more can change the operating agreement at any time. To avert this catastrophic clause, two business partners can agree that it takes 85% of the voting members to change the agreement. This means that if one business partner owns 49% and the other owns 51%, neither business partner can change the rule of governance without consent or vote of the other party.

Another area to focus on within the Operating Agreement is how to treat cash, profits and losses. You and your business partner should clearly communicate your expectation for how distribution should occur in these areas. Most businesses will issue a quarterly distribution. Usually at the time of filing taxes for the business, losses are distributed equally to individual members based on how much initial investment each member contributed to the business. You may want to consider to set aside a cash allocation for the business so it has its own resources for paying taxes, liabilities, or for future growth funding needs.

An Operating Agreement should have clauses on how to discipline a member or manager that has committed an act against the business, one so harmful that it puts the business in jeopardy of dissolving. Also, if a business partner decides they no longer wish to continue with the business, abruptly leaving another business partner with a host of liabilities, what terms and conditions are in place to protect the other members and business owners from these kinds of early exit decisions? An operating agreement can spell out the step by step process and under what conditions a member may exit the business, without being a detriment to the remaining business owners.

What if you are a sole proprietor? Do you need an Operating Agreement? The answer is yes and here is why. What if down the road your business experiences a change in circumstances that leaves you having to explore the option of partnering up with an investor or operational business partner? You want to have a rule of governance in place that spells out the very terms of that business’s ongoing policy so that the new business partner cannot impose any new self-rule or put at risk your previous years’ worth of financial investment and sweat equity.

The larger your vision is for your business operation, the more time you will want to devote to establishing agreements, rules of governance, guidelines and company policies, to assure the business can function, even when challenges from within arise. It is also wise to consult with legal counsel, an accountant, and a human resource specialist, so that you can take into consideration as many local and state laws and protections as part of your overall agreements.