10 things to discuss when negotiating an operating agreement

Katie Cook

ContractRoom

by Katie Cook

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Starting a new company or other corporate venture is exciting!  

To make sure you are on the same page with your partners discuss the following 10 points.  

This will ensure you are in the best position to promote your vision, bring it to fruition and avoid future disagreements.

1. Business Plan

Define what your product is. What are the short, medium and long term goals for your business?  How do you envision the company looking in six months, twelve months and five years? A business plan is a key document to securing investment, gaining a board of directors, and for setting the overall direction of the company.  It’s recommended that you update your business plan at least once a year, taking into account new competitors, new market conditions, and any changes to your company strategy.

A typical business plan consists of the following:

  1. Executive Summary
  2. Value Proposition
  3. Product or Service information
  4. Marketing Plan
  5. Operational Plan
  6. Financial Plan
  7. List and Profiles of the team
  8. Sources and Uses of Funds Statement
  9. 3-5 year financial projections

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2. Parties

It is important to define who the parties are involved in the deal.  This may seem obvious but unless this is specifically discussed it may come to light later that one person believed you were still looking for others to join the venture whereas another may have assumed only those persons already on board would ever be involved.  

Who are the investors? Are the partners involved related to any of the investors?  If so, other the remaining parties satisfied with this arrangement?  How will business agreements be negotiated with new investors and who has the authority to be involved in these negotiations?

Your operating agreement will ultimately determine who is in charge of conducting negotiations and how investment is handled.  Make sure you are all familiar and agree to abide by this document.

3. Purpose

What is the purpose and drive behind the company?  Is the sole purpose of the venture profit raising or is there a more global or philanthropic drive that you want to focus on?

A good mission, vision, and values statement will help with this, ensuring that the company has a solid purpose that everyone can rally behind.

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4. Competitive Activities

May those involve in the venture also engage in external projects that may compete directly or indirectly?  Do they need to bring any other ventures they are involved in to the attention of their partners and seek approval to continue simultaneous involvement?

Make sure to take stock of all your competitors and understand how you are different.  Execute this exercise on a regular basis to make sure to stay up to date on market trends and changes.

5. Capital Contributions

How much money has each partner contributed to the venture? Partners may have also contributed by providing property, whether intellectual, personal or real, services, or contractual rights.

Are there obligations falling on the partners to provide contributions as the venture progresses?  What are these requirements and what are the intervals at which these fall due?

Your operating agreement will govern this part of business and will help to determine ownership. Make sure that each member’s contributions, monetary or otherwise, are considered and recorded.

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6. Distributions

Each party should receive a return which reflects the amount of risk they have invested in the deal.  You will need to agree on the value invested by each party as well as the relevant amount of risk they are taking on considering the likelihood the project will be a success.  

The proper sequence for distributions also needs to be discussed and agreed upon.  This needs to take into account required loan repayments and what percentage is to be reinvested into the company.

Parties should also agree upon who has authority for and/or the process for making future changes to this sequence or decisions about distributions.

7. Profits and Losses

There are tax and accounting issues that are complex and require professional assistance in relation to the allocation of profits and losses.  Agree on the Accounting professional you and your partners wish to work with and set up an initial meeting so you can understand your obligations and options so you can agree on how you will proceed with allocating these.

8. Control

Who has Operational Control and who has Economic Control?  A partner with operational control can make decisions that affect the day-to-day running of the company such as engaging relevant service providers, signing relevant leases and employing staff.  If more than one partner is to have operational control you must agree on how conflicting ideas on how to proceed will be resolved.  

A partner with Economic Control has the power to make financial decisions about the company such as what to purchase, what to sell and setting the budget.  If one partner has Economic Control but not Financial Control a budget within which he or she is to work will need to be agreed upon.

More important decisions or in a larger partnership, decisions affecting the company may be needed to be made by more than one partner.  You will need to agree on the hierarchy of authority and the process for making these decisions so progress is not halted due to deadlocks in agreement.

It is also wise when negotiating control to agree on how a party can exit the deal in a situation where they do not wish to continue.  You may agree that parties can exit at the achievement of certain milestones or on the death or exit of a key player.

9. Transfer of Interests

You may want to restrict to whom or in what circumstances partners can transfer their interests to external parties.  It is common to add a right of first offer/refusal to an operating  agreement to provide remaining partners with further control.

10. Buy-Sell Provisions

Most of the time one partner will want to leave the venture before the remaining parties. The mechanics of how this exchange should take place.  

Processes for agreeing on pricing such as obtaining appraisals from relevant valuers should be specified.  What factors should these appraisers take into account? Do you want to agree at this point on a formula for how pricing should be calculated?  What will this formula be based upon - book value, capital accounts or multiples of earnings or a combination of these?

Is there any situation where a partner has the power to force a sale or purchase?

If all the above are thoroughly discussed, agreement is reached and what is agreed upon is reflected in the operating agreement your venture is more likely to proceed harmoniously and succeed.

What are your thoughts and experiences?  What do you think it is most important to discuss with your parties when negotiating and drafting an operating agreement?

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This article is made available by ContractRoom for educational purposes only and not to provide specific legal advice.  The article should not be used as a substitute for competent legal advice from a licensed professional attorney in your state.

About the author

Katie Cook

Katie Cook

Katie Cook is the Director of Marketing, Communications and Legal Standards at ContractRoom. Originally from the east coast of Australia, she has a background as an Attorney having practiced in both public and private practice in Brisbane and Melbourne. While working as an Attorney Katie completed studies in journalism and is now combining her legal and writing skill sets in her role at ContractRoom.

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