So, you and your little sister, Rachel, finally started that mitten-shaped decorative soap business you’ve always talked about – Nice! And your friend’s brother’s buddy helped you file for an LLC through the State of Michigan’s website and sent you the link to obtain an EIN from the IRS because the banks said you needed it to open a checking account. That’s it then, you’re all set and ready for the farmer’s market next weekend, right? Nope. You forgot to agree on the rules for running your business, the rules for how you and your sister will make the “big” decisions for your new company. We call these Operating Agreements and they are an important part of any small business – even if it’s just one person. There is nothing worse than having to stop the fun to argue about the rules in the middle of the game because no one can agree – no Rachel, landing on free parking does NOT mean you get all the money paid for the properties.
Let’s look at a few scenarios of how the life of your business can go awry without a one.
Scenario 1: You and Rachel start the business together and agree to split the business 80/20 since you put in all of the startup funding, make all of the soaps, and spend every weekend selling them at farmers markets from Port Huron to Petoskey, and all she did was set up the website – seems like a fair split. After a few months, things are going well and you decide to hire Rachel’s boyfriend, Ray, to expand your sales capacity and sell the soaps at more shows. Unfortunately, you quickly realize that Ray isn’t up to the task and he’s losing more soap than he’s selling – no biggy, you can just fire Ray (even though Rachel says Ray isn’t going anywhere); after all you own 80% of the business. Not so fast; because you and Rachel never signed an operating agreement that says that decisions would be made on the basis of ownership shares, you have to make decisions according to the Michigan Limited Liability Company Act (the Act) which says that each owner (the Act calls them Members) of the company gets one vote. So what now…the status quo wins and Ray stays.
Scenario 2: Rachel started a new company a few months ago and asks you to join. She did the usual start-up procedures like file the Articles of Organization to start the LLC and opened a checking account, but it was just her, so she didn’t think she needed an operating agreement. You both agree that the business is worth about $20,000 dollars, so you pay her that $10,000 you were saving to buy a new car. A few years go by and you and Rachel are happily employed by the company, pulling great benefits and a decent salary, and because you and Rachel work so well together, you even get a few thousand dollars in distributions every year. Unfortunately, Rachel decides to run off with Raul and sells out to her pal Rusty. After a week or two, Rusty tells you he appreciates you, but your services are no longer needed and terminates your employment. “Wait, what!?! We’re 50/50!” you say. Not quite, sorry. There was no operating agreement, remember? And you bought your share from Rachel. Rusty has talked to a lawyer and figured out that you are merely an assignee of 50% of Rachel’s interest in the company, you were never admitted as a member. So long great benefits and decent salary; oh and by the way, Rusty has no idea what he’s doing so those distributions are gone, too.
These two scenarios illustrate the pitfalls of small businesses failing to adopt an operating agreement for their LLCs. It may seem like an unnecessary step when you’re starting out, but waiting until the time is right or until you get big enough, can often lead to forgetting about it completely. If you are starting a business, or have started a business and you’re unsure about whether it is properly structured, you should make sure that you consult with an attorney who can help you write the rule book for your business and ensure that everyone is playing the same game.
This is a brief summary and does not constitute legal advice. If you have any questions, please contact Robert D. Burgee or your Fraser Trebilcock attorney.
Robert D. Burgee is an attorney at Fraser Trebilcock with over a decade of experience counseling clients with a focus on corporate structures and compliance, licensing, contracts, regulatory compliance, mergers and acquisitions, and a host of other matters related to the operation of small and medium-sized businesses and non-profits. You can reach him at 517.377.0848 or at email@example.com.