Operating Agreement considerations for “50/50” Business Owners

This post is for those of you thinking of starting a “50/50” business. Maybe you’ve done a bit of research and understand the value of a formal entity like a limited liability company and have an idea of how a statutory limitation of liability works. You may have also read that the key document in an LLC is the “operating agreement.” From there I’m sure you realized that you can quickly download a two-member LLC operating agreement off the internet FOR FREE and be on your way!

If that’s where you are, this post is for you. I think a 50/50 operating agreement between new businesspeople is a difficult legal document to develop and write, and I want to lay out some of the key complications and challenges involved. I want to give you the chance to reconsider that internet operating agreement.

Speaking generally, a careful and well-tailored operating agreement differs from the free document in some fundamental ways: (1) it clearly establishes your financial and management rights; (2) it addresses common but difficult contingencies you can expect to encounter on your way towards success, and (3) it does not strand you with an “agreement to agree” when you arrive at a disagreement. Also, the process of developing the operating agreement is an important exercise for new business owners.

Establishing Agreement and Understanding

The key principle behind the LLC operating agreement is … an agreement between the members. That is, the operating agreement is the instrument by which the LLC owners agree to formalize their business relationship. An operating agreement typically addresses issues that can lead to challenging conversations for inexperienced owners, and the process of talking through those issues can really build and reinforce your business relationship. On the other hand, if you don’t talk through those issues and sign a random document anyway, you have tied your business relationship to … who knows what? I’ve read a few internet operating agreements recently, and they are madness! The worst ones look very official but are actually written in nonsense language – in short, they are worse than having nothing.

[Also, please don’t download some piece of google and then ask your lawyer to do a “quick review.”]

Distinguishing Ownership and Management

The operating agreement establishes your respective financial rights and management rights in the business.

I like operating agreements to create separate ownership and management: in a 50/50 arrangement, each owner would be a Member and a Manager. With only two people, each in both roles, it can seem redundant or pointless at first, but the two roles have different rights and duties, and as the business matures you may want to add other Members or Managers, or transfer your Member or Manager roles to others, and it’s good to have the structure in place. For instance, there may be a time when you want to retire from running the company but keep getting profits income, so you want to hire a new outside manager. Or you may have a chance to sell your membership interest in the company but want to keep your job as Manager.

Your rights as a Member typically begin with investment in the company. Members are the ultimate authority in an LLC, and delegation of all other rights flows from Member rights. Typically an operating agreement will give Members the right to elect and oversee the managers; while the Managers are appointed by the Members to be responsible for running the business and making a profit for the Members.

No matter how much authority is apportioned to Managers, Member and Manager roles are structured around (1) financial rights (who gets paid, how much, and when?) and (2) management rights (who gets to do what, and who do they have to ask?). The financial and management rights for Members and Managers can be apportioned with a great deal of discretion and flexibility, but whatever the structure is, it has to be described as clearly as possible.

It's important to establish the scope of the Member and Manager roles as crisply as possible. Every company is different and a frank talk about who does what reveals a lot about the way the Members see themselves. It’s not uncommon for Members to come out of a detailed conversation about duties and compensation with the realization that they don’t actually want a 50/50 split.

Disaster Planning

A thoughtful and accurate operating agreement is especially helpful for 50/50 members because it is designed to anticipate and address situations where friction typically arises between owners. It’s a kind of disaster planning, or “contingency” planning.

Members will have disagreements as the company grows. In a 50/50 company especially, a serious quarrel between the Members can paralyze the operations of the company and undermine the operating value of the business they’ve built. Accordingly, I like to draft operating agreement mechanisms geared to resolve difficult issues in a way that preserves the value of the business even at the expense of one of the Members. (That is, if you can’t agree on critical matters, one of you has to go before you ruin the company.)

The first class of disagreement comprises fundamental imbalances between the Members. The second, matters where a Member’s self-interest conflicts with the path of the Company or the other Member.

Fundamental imbalances are things like the following:

• Capital vs Labor. Has one of you put in most of the money, with the other promising to do most of the work?

• Essential Qualifications. Does the business depend on the professional skills or qualifications that one of you brings to the company (e.g., an engineering degree, or arborist skills?)

• Financial Investment (“Who has more money?”). Is one of you investing your life savings into the business while the other can afford to lose their investment? If there’s a need for more capital, can only one of you afford to contribute?

• Emotional Investment (“Who wants it more?”). Is the business a lifelong dream for one Member, but a more casual commitment for the other?

As a business grows – especially if the business is successful – these imbalances can become irritations that turn to resentment and feelings that the 50/50 arrangement is unfair to one Member or the other. You can talk through the imbalances in advance and perhaps not resolve them but develop a clearheaded plan to accommodate them in the operating agreement.

Typical self interest-based disputes are more varied.

• What if only one of you wants to sell the Company?

• What if only one of wants to take on a new member?

• What if one of you thinks the 50-50 ownership structure is not fair anymore?

• Who can give or take away management authority?

• Who can change the purpose or direction of the business?

• What if one of you wants to start or end a significant line of business?

• What if one of you wants to do work for a competitor?

• What if one of you wants to sell your interest to a third party? (And that third party is your niece, right? It’s always a niece.)

• What if one of you dies or becomes disabled, or goes to jail?

• What if one of you wants to quit or retire?

• What if one of you does something bad, like embezzle or defraud the company?

• What if you lose your ownership interest in a lawsuit, like a divorce?

• What if you can’t agree on a major business decision and the company is deadlocked?

Valuation and Transfer Issues

• In any case of membership transfer, what is the value of a Member’s units? What’s the formula for determining value?

• In any case of membership transfer, is the transfer discretionary or mandatory?

Now look at that document you just printed from the internet. It’s going to be a member-managed arrangement that says the members will agree on any important matters that arise in the business. Didn’t I just list a bunch of things that you’re not going to agree on? Well, by definition, that agreement-to-agree is not going to work. Let’s say you get a great job opportunity, so you want to walk away from the business, get paid half the going concern value, in cash, and stroll on over to your new job working for a competitor; on the other hand, your partner thinks you should forfeit your interest as a penalty for screwing the business and pay her legal fees for the lawsuit she’s filing against you tomorrow. That’s a disagreement that would be anticipated and addressed in a good operating agreement (because you’ve agreed in advance on how to handle it), but you can see how a mushy agreement-to-agree is going to fail in this critical dispute.

The reason the 50/50 operating agreement is hard for lawyers to write is that we have to get through some hard conversations with you, then build the conclusions into an appropriate, enforceable form. It always seems to take more time than you think. For you, it is an investment in business discussions with your partner that will produce a useful, comprehensible document that can be a touchstone in your maturing business relationship.