When your business is new and you feel like you have thought of every possible issue that may arise, it can seem unnecessary to formally draft an operating agreement for your business. However, it is difficult to anticipate every event that may come up, especially where you are working with other business partners. Additionally, you never know when miscommunication, misunderstandings, or conflicting ideas, may cause mistrust between partners. Failing to have an operating agreement can jeopardize your business, personal assets, and working relationships.
Below we discuss eight reasons an operating agreement is essential for your business.
1. Liability Protection
An operating agreement helps differentiate your personal assets from your business assets.
The best way to separate your business assets from your personal assets is to delineate all business assets in your operating agreement. This will help protect against what is known as “piercing the corporate veil.” Veil-piercing is an attempt, by a creditor or plaintiff, to have the court set aside the business’ limited liability protection due to the owner and the business acting as one in the same. Veil-piercing can be avoided by distinguishing your business as a separate entity from you as the owner.
Note: Even where an agreement makes the distinction between ownership, you must be careful not to commingle funds and assets as well as maintain separate corporate documents.
2. Avoid Arizona Default Rules
If your business does not have a specific plan written on how to manage operations, distribution of profits, etc., Arizona has default rules of business in place to fill these gaps. While the default rules are not necessarily bad, they will greatly limit your decision-making power and control. As such, if you know you want specific actions, persons, and organizations to be involved in or manage your business, it is crucial that you spell that out in your operating agreement.
3. Banks and Investors May Require It
Banks and Investors are fond of operating agreements because they can help verify ownership and signal legitimacy and stability in your business. While they generally do not focus on the internal operational information contained in your agreement, it will give them peace of mind that your business is authentic. It will also have the effect of giving them confirmation that any persons acting on behalf of the business truly has authority.
4. Delineate Day-to-Day Responsibilities
Often, business owners wear many hats when it comes to operating their business. Sometimes the business is owner or member-managed, and other times it is manager-managed. A manager-managed business model is when the owners rely on other people and employees to manage some or all of their day to day tasks. For example, a restaurant owner may not visit the restaurant every day, but will hire a restaurant manager in addition to wait and cooking staff. In the operating agreement, the owner can map out all the responsibilities and authority the manager will have to avoid confusion and unauthorized actions.
5. Scalability – Map Out Your Business’ Future
An operating agreement can plan for the future growth of the company. Addressing issues like what type of investors they want or need, how many investment shares will be given, and what rights and authority new investors will have. It is smart to have a good understanding of the desired future structure of your business so you can narrow in on smart investment and growth opportunities as they arise.
6. Decide on Ownership and Management
a) Ownership Shares – Where a business has many members or partners, defining the allocated percentage of ownership as it relates to the percentage of capital investments is important. Discussing this in your operating agreement can help identify controlling ownership interests and management rights. This is especially important where one member may contribute more financially, but another member does more of the day-to-day operational work.
b) Voting Rights and Responsibilities – Voting rights may be distributed in various ways. They can be equal to each member’s contributions or, all members can have an equal voting right, this should be tackled in your operating agreement.
7. Contributions and Distributions
a) Startup Costs – Initial capital contributions upon the formation of your business are the cornerstone to getting your business up and running. Owners usually contribute enough to pay startup expenses and accumulate initial assets. Typically, a member may only share in profits if they contribute some amount of capital.
b) Distribution of Profits and Loses – Often the percent of profits received is causally related to ownership percentage, however, you may decide on a different percentage or division in your operating agreement.
8. Determine an Exit Strategy
a) Buy/Sell Rules – If a member leaves the business, you need to determine how to handle their ownership interests. Accounting for this in your operating agreement will ensure your business continues to run smoothly should someone leave. Commonly used provisions include allowing other partners the first right to buy the leaving member shares and permitting transfer of shares to a family member. You should also mention rules for adding a new member following a member’s departure.
b) Dissolution – Ending the Business – It is essential that you address any action that should be taken when dissolving your business, including the payoff of creditors and how assets should be sold and divided.
As you can see, operating agreements can provide security and direction for nearly every aspect of your business. These agreements should be one of the very first steps you take in setting up your business, however, even if your business is already operating, you can still put one in place. Better late than never.
Contact Counxel Legal Firm
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This article is intended for informational purposes only and does not constitute legal advice for your specific situation. Use of and access to this article does not create an attorney-client relationship between you and Counxel Legal Firm. Please contact request@counxel.com or (480) 744-6621 to request specific information for your situation.
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