An operating agreement is a crucial, foundational document used by limited liability companies in Michigan (and elsewhere) to govern how major decisions are made, how ownership is structured, and other important functions. It’s a contract that binds the owners to an agreed upon set of rules. Having an operating agreement in place is a formality that helps preserve the business’ limited liability status and prevents the business from being subject to the state’s default rules regarding LLC operations.
Despite these and other reasons for businesses and their owners paying careful attention to what their operating agreement says, how it’s said, and who is advising on those matters (i.e., are they working with a lawyer who has significant experience drafting operating agreements), we still see way too many businesses make the same avoidable mistakes when it comes to creating operating agreements.
Here are seven of the most common.
- Not Having One. Too many partners who start new businesses together state their intention to create an operating agreement, but never get around to it. As a result, they’re stuck with Michigan’s default rules. Others simply copy and paste from a template they find online, which can lead to disastrous results—for example, including choice of law provisions from some far-flung state. A more understandable, yet still unadvisable, situation where an LLC operates without an operating agreement is when it’s a single-member LLC. Even in that case, an operating agreement should be created to adhere to corporate formalities, avoid state default rules, and as a foundation for future growth.
- Omitting Sections. Many provisions of an operating agreement are straightforward. Others, however, require careful consideration and, at times, negotiation among the members. Anxious to get on with the business of running their new business, it’s not uncommon for owners to “put a pin” in certain issues—such as what happens in the event of a departure of an owner from the business—and exclude it from the agreement with an intention of revisiting later. But they rarely do. It’s almost always better to work through the difficult issues from the beginning rather than kicking them down the road for later.
- Leaving Sections in That Don’t Apply. The other side of the “omitting sections” coin is leaving sections in the document that don’t apply. This “kitchen sink,” more is better approach to operating agreements usually results from the failure to work with a lawyer who knows what they’re doing or not working with a lawyer at all. A stray provision that doesn’t belong may just seem like superfluous boilerplate one day, but can cause a big problem the next.
- Ambiguous Language. The purpose of an operating agreement is to create clarity. The parties’ intentions get documented and a roadmap for operating, decision making, distributing and/or contributing funds, and other important matters are all clearly spelled out. Unfortunately, that’s not always the case. Instead of doing the hard work of creating clear rules, processes and guidelines, the agreement gets peppered with ambiguous terms like “in good faith” and “best efforts” that sound lawyerly but are mostly used to gloss over areas where the parties can’t agree to a definitive standard to govern how they’ll operate. A little extra effort and experienced legal counsel can help to avoid the ambiguity.
- No Follow Through on Buy/Sell Agreements. A buy-sell agreement is a legally binding contract, often made part of an operating agreement or bylaws, that governs how an owner’s share of a business may be reallocated. It enables succession planning when certain triggering events require a business owner to sell, or offer, their ownership interest in the business to their co-owners. Many buy-sell agreements provide that a business will obtain life and/or disability insurance on each of the owners, the proceeds of which are used to fund the payment upon the death or disability of the departing owner. It’s all too common, however, for life insurance to be established as the mechanism for funding a buy/sell agreement, but a policy never gets bought. On paper it all works—but there’s no financial means of funding the buyout.
- Not Revisiting it from Time to Time. An operating agreement for a business is more or less analogous to estate planning documents for an individual. It’s pretty easy to understand why an individual should revisit their estate planning from time to time because circumstances change—people get married, divorced, have children, etc. Their estate planning must also change. The same principle applies when it comes to an operating agreement. Members may come and go. The nature of the business may shift. State or federal law may change. It’s a good idea to meet with legal counsel once a year to review whether your operating agreement needs to be amended.
- Failing to Sign. I saved this one for last because it doesn’t require much of an explanation. But that doesn’t mean it’s not a common problem. There are countless examples situations involving drafted-but-never-signed-agreements that no one realized would be a problem until the owners get into a dispute and one tries to enforce the agreement’s terms against the other. An easy way to avoid this mistake is to get a lawyer involved—one of the things most lawyers are good at is making sure that documents they draft get signed by the parties.
We are here to help you and your business. If you require helping in incorporating a business, creating an operating agreement, or have questions about your existing operating agreement, please contact Zana Tomich, co-founding partner of Dalton & Tomich.