Continued from Mistake #1: Choosing the Wrong Ownership
Mistake #2. Not Having an Operating Agreement
(Partnerships and Corporations)
An “Operating Agreement” is a contract between the founders of the business. This includes people involved in the management, people who provide capital, and people who do both. This agreement sets out operative issues in advance such as who does what, when they do it, and how they do it. This ensures that everyone knows what needs to be done, and, as a result, the cost of solving problems will be kept to a minimum.
The types of issues often addressed in an operating agreement include:
- how much time and effort each person contributes;
- what each person’s responsibilities are;
- how much capital each person contributes;
- what happens if the business needs more capital;
- what happens when a person leaves the business;
- what happens when a person dies; and
- any additional details imperative for, or unique to, the business.
Operating agreements are often over-looked. This is especially true in cases where the business partners are related or are friends. In such instances, the partners enter into the transaction assuming the best of one another and not anticipating the number of things that can go wrong over the life of a business. However, the consequences of not having an operating agreement usually emerge quite quickly. What happens when expected capital is not provided? What happens when a married partner gets divorced? What happens when partners disagree? These kinds of issues arise frequently and can get very messy very quickly. They can destroy both business and personal relationships.
Just as important as having an operating agreement is understanding it. It needs to be clearly drafted, and everyone who signs it needs to know what is in it. Failure to understand the terms of the operating agreement is one of the most common causes of in-house disputes and partnership conflicts. When a dispute arises, the operating agreement will be the decisive document in settling the dispute – its creation and comprehension are critical.