To run a business successfully, you’ll need to have more than just a product to sell or a service to offer. You’ll also need a plan and a set of rules and laws to help guide all the stakeholders in your organization. This "agreement" helps set a foundation in the business's governance and is created to assist owners and managing members make the critical decisions needed to run a company efficiently.
These established rules are aimed to assist business owners — including partners and managing members — and ensure that the company operates smoothly, as well as to mitigate internal disagreement and resolve questions on how the company should operate.
Whether you run your business as a partnership or have a multi-member LLC, these types of agreements will help diminish risk while ensuring that everyone involved in the business is on the same page as well as legally protected. And to state the obvious, having an agreement in writing with the understanding that it is a contract is critical, as opposed to having these agreements made verbally where potential misunderstanding and confusion can ensue.
So, do you need a partnership agreement and an operating agreement? Do partnerships have to have an operating agreement? Let's go over the difference between a partnership agreement and an operating agreement, what these agreements commonly include and why they're so important to a business.
What Is a Business Partnership Agreement?
Have you ever thought about going into business with a good friend or bringing on a business partner whose great ideas jive well with your own? While it may seem simple, joining forces with a like-minded entrepreneur to form a business partnership doesn't come without risks.
A business partnership agreement is a contract between all parties involved in a joint business venture. It spells out the terms and conditions of the partnership, which can include:
- The official name, place and purpose of your business
- The percentage each partner owns in the company
- How much capital each partner is putting in
- Who makes the financial decisions and how final decisions are made
- How profits and losses will be distributed
- A detailed description of the management role and responsibilities of each partner
- How often official meetings to formally discuss the state of business will occur
- The length of the partnership
- Whether or how a partner can sell their share of the business (or purchase another)
- How and why the partnership may be dissolved
Besides covering all your bases, a business partnership agreement includes provisions that are specific to your business and the arrangement that you've all agreed on. It can also even cover additional uncertainties, such as what happens to the business when a partner dies.
What Is an Operating Agreement?
An operating agreement functions in the same way as a partnership agreement and is a legally binding document. It outlines the ownership stakes (percentages) of its members and how the company is managed, including when meetings are held, naming managers and even dropping or adding members.
A Limited Liability Company (LLC) is governed by a state’s LLC laws, so make sure to check your Secretary of State website for rules.
You can think of an LLC as a business structure that's a hybrid between a corporation and a sole proprietorship: it combines the pass-through taxation of a partnership with the limited liability of a corporation. It's a popular structure because it’s simpler and more flexible than a corporation.
If you have business partners, you can draft up a partnership agreement for an LLC to protect the personal assets of everyone involved. Each partner in an LLC is called a "member." With an LLC, a small business operating agreement is a contract among the LLC’s members that stipulates the LLC's membership, management, operation and distribution of the company’s income. It also documents the roles, responsibilities, rights and relationships of the members, as well as their respective ownership percentages and shares of profits and losses.
5 Reasons to Have a Business Partnership Agreement
While you may be excited to start a new venture with someone, it's important to have everything in writing from the start so you can begin operations accordingly. Plus, you need to be prepared in case things go south and you need to dissolve the company. Even though you may have worked with your partner before or been friends for years, having a written contract that is legally binding helps you achieve the following:
- Define ownership, roles and responsibilities
- Clarify capital contributions of each partner
- Determine salaries
- Avoid tax and liability issues
- Deal with changes and problems
5 Reasons to Have an Operating Agreement
Much like a partnership agreement, having an LLC operating agreement will help to:
- Outline the company’s management structure
- Include a plan on how the profits are distributed among the members
- State that members are not personally liable for the business debts incurred by the business
- Provide clarity to the agreements and terms established with the members and their interests, including roles and responsibilities within the organization and contributions and consequences for failure to meet their duties
- Set out the different ways for dissolving the business, including the sale of the LLC
States That Require an Operating Agreement
To date, only five states require an operating agreement. (Not to be confused with Articles of Incorporation required by most states.) These five states are:
- New York
Although the number of states that require an operating agreement is small, having such a document will help avoid misunderstandings that could derail a business. Operating agreements help establish the roles of the members and offer a set of agreed-upon rules to help secure each member's stake in the business.
Finding the Support for Your Business
There are plenty of reasons that having a partnership agreement or operating agreement is crucial when starting a business with a colleague or multiple members. It not only helps define your business, but it helps you come up with an action plan in case of changes or unexpected events. If you have specific questions about your business case, you should seek the professional advice of a legal expert.
If you're ready to create a business partnership agreement or need to learn more, let the Incfile team help. We can help you customize an operating agreement for your company.