Starting an LLC with partners can be exhilarating. It is an excellent vehicle to learn business practices with a minimum of personal risk. Most people who form LLCs know and trust each other. LLCs, for this reason, are often compared to a marriage.
Suppose five people form an Indiana LLC. They are friends from business school. Each person plans to specialize in an area of the company. One member will perform executive oversight, and the other four will respectively be responsible for accounting, sales, finance and production. Each person will hold a 20 percent interest in the LLC.
A smooth beginning
The five friends hire a business school colleague to set up their LLC. He has experience as a law clerk and says that Indiana does not require an operating agreement for an LLC; however, he shares the marriage analogy and likens a good operating agreement to a prenuptial agreement. The five partners skip the operating agreement since they trust each other to behave honorably.
Things run smoothly for several months. The LLC is up and running, sales are consistently growing, and the LLC considers developing more products. After two years, the business is profitable. The partners hold weekly meetings to discuss items that require their attention. They also work on plans for future improvements.
A bump in the road
Just as the partners are ready to initiate a new product line, friction occurs between the accountant and the production manager. They disagree on some added features the production manager feels will provide a marketing edge. The sales manager backs him up. The finance manager gets nervous and aligns with the accountant’s opinion that the suggested additions are not feasible. The LLC finally has an impressive $570,000 in its business checking account and the money men want to keep it there.
The five partners hold a special meeting to hammer out a plan that will satisfy all of the partners. The angry production manager, to the partners’ surprise, storms out of the building. They continue the meeting without him. Meanwhile, he drives to the LLC’s bank and withdraws $550,000 before heading to the airport.
Operating agreements and disasters
When the remaining partners discover the financial loss, they contact their law clerk friend. He suggests they could litigate, but first, they would need to find the missing partner and, more importantly, figure out where he hid the missing funds. Technically, the absconding partner did nothing illegal at the bank; all five members had unrestricted access to the business account. There was nothing in writing that prevented him from making the withdrawal.
There is a reason an LLC needs to set up a strong operating agreement. In this illustration, the five partners should have organized their entire company through a professional who could have guided them in best practices to protect their interests.
