The good, The Bad, The Ugly - Why Every Business Needs Operating Agreements

Because the cannabis industry is young and rapidly growing, there is a tendency for businesses to be lax in their partnerships and see a handshake as “good enough” when it comes to sealing the deal. As founder of a law firm specializing in cannabis law and policy providing legal protection and compliance to brands, I have met with many potential clients who face surmounting legal battles with little chance of beneficial resolution which could have been prevented had there been an operating agreement between both parties. Having an operating agreement put in place from the start could be the difference between a fair split where both parties are compensated for their efforts and having to go to court in order to sever ties under a judge. At some point during the life of a business, issues will arise, and an operating agreement is an integral tool to help eliminate potential frustration and animosity, ultimately protecting all parties.

Importance of Operating Agreements

An operating agreement is a foundational legal document used by limited liability companies (LLC) to outline the rules and regulations by which the company and its owner(s) will operate or function. Operating agreements are similar to “prenuptial agreements” in necessity and are created to protect all parties in a “business marriage.” However, they are even more important for cannabis companies when it comes to function. Because the cannabis industry is so heavily regulated with an ever-changing legal landscape, it is essential that everyone understands the expectations from the outset of a business relationship.

An operating agreement can include almost any terms that a business wants it to include. Most attorneys will recommend  agreements stipulate the following:

1) Members of the company;

2) Decision making procedures by those members;

3) How finances are divided (this includes profit, loss and debt);

4) Milestones that each party should meet, including consequences for failure to meet those milestones, and;

5) Procedures, planning and desired outcomes in the event the company needs to be dissolved

Maintaining an operating agreement defines the way in which the business will operate and seeks to resolve some of the most common issues experienced by businesses such as who is in charge, who can join the company, how others join the company, what happens if a member leaves or passes away, what happens if the company runs out of money and so on. When drafted properly by an attorney, these documents can save business partners from disputes, and any potential ill will that stems from common issues in doing business. Operating agreements help protect the overall health of the company and the productivity of its members. When there is established guidance for how the business(es) will operate, less time is spent over ownership and responsibilities which have been defined to streamline focus on customer care and profits.

Many banks require an operating agreement to open a business account. And while it might be tempting to go the fast and cheap route of getting something drafted from an online service or a do-it-yourself template from a Google search, it will likely not be detailed enough to help the business when something more serious comes up in the future. For example, if a business partner attempts to push a member out by means of locking that member out of the physical property, accounts, and communications.

An investment to protect your future

At the outset of most businesses, everyone has rose-colored glasses on. There is excitement and love for one another and the thought of a verbal agreement or a handshake not holding up is something that cannot be imagined at the time. Most young cannabis businesses may not understand why they should; or even know they should prioritize this investment on the frontend in order to help protect them for the future, and unfortunately when it is needed, it is usually too late.

Cost is usually the determining factor as to whether or not a cannabis business will work with an attorney on creating  an operating agreement. It is recommended to have the agreement drafted by an attorney since they have the experience and knowledge to help a company foresee potential issues one, three, five or 10 years down the road. Operating agreements are a significant part of a business’ safety net. They can offer protection of personal assets from the IRS and debt collectors, they serve as protection in a lawsuit by external parties and consumers, and they can help limit or potentially avoid litigation with business partners.

Some business owners cite that not having an operating agreement resulted in losses upwards of $50,000 in potential revenues. An ironclad operating agreement can cost business owners anywhere from $2000 to $7000, or more depending on the specific needs of the business. When done properly, it is drafted as a living document that grows as the company grows. It is recommended to be reviewed and updated yearly. If thoroughly drafted the first time, it can be updated during pivotal milestones such as adding new partners, achieving profit targets, company shifts, and so on. A comprehensive operating agreement that is drafted proactively, with avoiding potential catastrophes in mind can save a company tens of thousands of dollars in litigation and attorney fees. Where most business litigation could cost a minimum of $10,000, investing in an operating agreement on the frontend can help ease or avoid these costs altogether.

Operating agreements can also benefit an individual acting as a business such as content creators, freelancers, etc. Even if someone is operating as a single-owner LLC, they  need an operating agreement. When an individual forms an LLC, they are forming a legal entity separate from themselves as a person. Obtaining an operating agreement helps protect personal assets from claims made against their business and helps strengthen the liability shield created by forming an LLC.

Conclusion

The recommendation for a business or person acting as a business to obtain an operating agreement is ultimately for the protection of all parties. What may feel like a large investment on the frontend, can save tens of thousands of dollars in the long run. Though it is never the intention for people going into business to find themselves in a position where they would need such terms drawn out,  things happen, people fall out of favor, and businesses evolve. Adding an extra layer of protection is the wise thing to do when it comes to protecting yourself and your assets.