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What is an operating agreement? When should you review it?

| Feb 11, 2021 | Buying A Franchise, Corporation Or LLC, Starting a Business |

When you launched your business and set up a limited liability company, you probably signed an operating agreement. Your operating agreement is essentially an agreement among the owners about how the business will be operated. Most importantly, it addresses how to resolve disputes between owners and what happens in the event of death, divorce or disability of one of the owners or a disagreement about how to proceed. Many small business owners have an attorney create the operating agreement when they incorporate the business and don’t think about it again until there is a problem. Unfortunately an outdated or inaccurate operating agreement can make a business dispute even worse.

A wise small business owner should review their operating agreement annually to make sure it still reflects the reality of their business. If you were and remain the only owner (“member”) of the company, that agreement you signed may not need to be revised. However, if you have added, or are considering adding, one or more additional owners, it may be time to make changes.

Most importantly, every time the membership of a company changes, small business owners should review the dispute resolution sections of the operating agreement. There are many possible ways to resolve disputes.

The first step is to identify the types of disputes that the process will apply to. Whether any small daily disagreement can be the subject of a dispute resolution process or if it is limited to only disputes that meet a pre-agreed threshold. Complete absence of prior agreement can leave the company mired in disputes and even lawsuits. It can take months or years to make even minor decisions. A well-drafted operating agreement will provide a mechanism for easily and quickly making daily decisions while reserving more complex dispute resolution processes for major disputes—disputes that go to the heart of the company’s ability to do the business it was created to do.

The second step is to provide a mechanism for resolving those major disputes, if and when they occur. The possible mechanisms can run from letting a mutually trusted third party decide, to an arbitration procedure, to litigation, or to a forced buy-out by one party (or side) of a dispute. The creativity of the parties and their counsel is the only real limiting factor.

The key to a good dispute resolution mechanism is that all of the parties have confidence in it and feel that it is fair. It always is better to write the rules at the beginning rather than after they are needed. Once business partners are in the middle of a dispute it can be challenging to cooperate and establish or update a dispute resolution process. And if the partners can’t decide—a judge or arbitrator might have to decide. This creates unnecessary expense and wastes time. Ultimately it puts the business at risk.

Your experienced small business lawyer can help guide you through the process. Change affects almost every business. It nearly always affects a business when a new owner joins for any reason. You can be ahead of the change by getting your operating agreement reviewed before the change occurs, and, in any event, before the first disagreement surfaces.