(Not So) Hidden Risks of Skipping an Operating Agreement for Your Texas LLC or Partnership

Starting a business with a trusted partner is an exciting and promising venture. Much like a marriage, you’re excited for the future, convinced of the success of the partnership, and blissfully ignorant to the myriad chaos that will ensue if the relationship sours with no rules in place about how to handle the break-up. 

You are most certainly eager to get things moving, but before you do, there’s one critical step that can’t be overlooked—signing an Operating or Partnership Agreement. This document is crucial for ensuring that your business runs smoothly and that all partners are on the same page.  After all, as long as everyone knows the rules, all is fair in love and business. Failure to sign an operating agreement leaves the company subject to the default rules within the Texas Business Organizations Code (TBOC) and, while our legislature did a good job, these may not be the rules you want to abide by. 

Let’s explore why neglecting this step can lead to significant pitfalls, especially in Texas, and how a lack of agreement could even result in a lawsuit.

One of the first and most important things to clarify in an Operating or Partnership Agreement is ownership. How much of the business does each partner own? Ownership is typically expressed as a percentage interest in the business. Without an agreement, Texas law may default to an equal ownership split, regardless of each partner’s contributions.

Exhibit A:

Imagine two friends, Rick and Morty, start a business together. Morty contributes 80% of the startup capital, while Rick contributes 20%. Without an agreement, Texas law might default to a 50/50 ownership split. Over time, Morty might feel that this split is unfair, leading to resentment. If the business becomes profitable and Morty wants a larger share of the profits, but Rick refuses, this disagreement could easily escalate into a lawsuit over ownership rights and profit distribution.

• With an Operating Agreement: They could have specified the exact percentage of ownership for each partner, reflecting their contributions, whether in cash, property, or services. This would have ensured that everyone’s stake in the business was clear and agreed upon from the start.
• Without an Operating Agreement: Disputes over ownership percentages can lead to friction, legal battles, or worse. Emotions run high when money is on the line and the fuel of resentment can create some pretty big fires. As seen in the example above, Morty might sue Rick to claim a larger share of the business based on the initial capital contribution and the resulting battle could eat into the productivity of the company and the contents of both of their wallets.

How will decisions be made in your business? This is another critical area where an agreement is essential. Will every decision require unanimous consent, or will some decisions be made by majority rule? How much weight does each partner’s vote carry—will it be based on their percentage of ownership?

Exhibit B:

Suppose Morty and Rick disagree on whether to take on a large new project that requires significant investment or the hiring of specialists or expansion into a new dimension. Morty, owning 80% of the business, believes that his opinion should carry more weight. However, Rick insists that all major decisions should be made unanimously. Without a clear agreement, this disagreement could result in a deadlock despite the fact that Morty contributed more capital to the company initially, preventing the business from moving forward. If Morty decides to move ahead without Rick’s consent, Rick could potentially file a lawsuit, claiming that Morty’s actions were unauthorized and harmed the business.

• With an Agreement: They could have detailed how decisions would be made, ensuring all voices are heard fairly or, in the event they still could not agree, there was a predetermined method for curing a deadlock. For example, you might decide that operational decisions require a majority vote, but major decisions like taking on new debt or selling the business require unanimous consent. You can also assign voting power based on ownership percentages, so partners with a larger stake have more influence. Or maybe even a tiebreaker provision in the event of a deadlock. Who can make the most three-pointers in a 2-minute stretch? The winner’s decision takes the day.  You’re only limited by your imagination (and not breaking the law) but any form of tiebreaker is better than none.
• Without an Agreement: The lack of clear decision-making rules can lead to confusion, disputes, and potential legal action, as with the example above, if Morty decides to unilaterally move forward without Rick’s consent, Rick’s best recourse may be to seek court intervention and that is a costly option. 

How much will each partner contribute to start and run the business? Contributions can come in the form of cash, property, or services, and these should be clearly outlined in your agreement. Additionally, what happens if the business needs more money down the road?

Exhibit C:

Imagine the business hits a rough patch and needs additional capital to stay afloat. Morty, who has already contributed more, refuses to put in more money without a formal agreement in place. Rick, who expected equal contributions, feels betrayed and decides to stop participating in the business altogether. 

• With an Agreement:  Morty and Rick may still disagree as to the necessary financial contributions to keep the company going but there will be rules in place on how to handle the dispute.  With an early agreement by the partners, you can specify each partner’s initial contribution and decide whether additional contributions will be required in the future. You might agree that if the business runs out of cash, partners will contribute more funds, or you might decide to close the business if it becomes financially unsustainable. Or, you could put in a provision that allows a partner who refuses to contribute more capital when needed to forfeit some of their membership interest to the partner who does contribute the needed capital. Where ever you land, though, it isn’t court.
• Without an Agreement: Disagreements over capital contributions can lead to resentment and potentially legal disputes, as seen in the example above between Morty and Rick’s differing expectations. This disagreement is ripe for allegations that one partner is breaching their fiduciary duty to the company and, naturally, a lawsuit to that effect. 

This is a big one. Where does the money go?! How will you allocate profits and losses among the partners? This is another crucial area that should be covered in your agreement. You’ll also want to detail when and how partners will be repaid for their contributions and how they’ll receive distributions from profits.

Exhibit D:

After a few years of successful operation, the business generates substantial profits. Rick expects profits to be split equally, while Morty feels entitled to a larger share because he contributed more capital and Rick’s service contributions did not match the capital provided by Morty. Without a clear agreement, this dispute could escalate into a lawsuit, with each partner claiming the other is not honoring their original understanding of profit distribution.

• With an Agreement: If they had reached an agreement at the outset of the company as to how profits and losses would be allocated, there would be significantly less to argue over when money started coming in. With an operating agreement, you can define a clear formula for distributing profits and losses. For example, profits might be distributed in proportion to each partner’s ownership interest, or you might agree to repay initial contributions before distributing profits. You can also decide on a schedule for distributions, ensuring everyone knows when they can expect to receive their share.
• Without an Agreement: Well…the lack of clarity on profits and distributions can lead to serious conflicts and potential legal action. Without a clear agreement, this dispute could escalate into a lawsuit, with each partner claiming the other is not honoring their original understanding of profit distribution.

What happens if a partner dies or becomes unable to continue operating the business? This is an often-overlooked scenario that can have serious implications for the business.

Exhibit E:

Rick suddenly passes away from causes unknown, leaving his share of the business to his spouse, who has no experience or interest in the business and thinks Morty is a slimeball who was never a good business partner to Rick anyway. Morty, now forced to work with someone who has no understanding of the business and hates his guts, feels trapped (because he is). 

• With an Agreement: An operating agreement in these situations allows for you to include provisions that outline what happens in the event of a partner’s death or disability. For example, you might specify that the remaining partners have the right to buy out the departing partner’s interest, or you might decide how the deceased partner’s share will be passed on to their heirs. Where ever you land on it, at least you have a plan of action for this circumstance.
• Without an Agreement: The death or disability of a partner can lead to chaos and potential lawsuits. At a minimum, the surviving partner has to deal with the heirs of the deceased partner.  In Morty’s case, he has to deal with a widow who hates him. Working with her or buying her out will likely both be difficult tasks. Without an agreement specifying what happens in this situation, Morty might sue to buy out the spouse’s share or dissolve the partnership altogether.

If a partner wants to leave the business, how can they do that? And if you want to bring on a new partner, what’s the process? These are important questions that should be addressed in your agreement.

Exhibit F:

Rick decides he wants to leave the business to pursue other opportunities. Without a clear process for withdrawal, Morty and Rick can’t agree on the value of Rick’s share or how the business will continue without him. This disagreement could easily lead to a lawsuit, with Rick demanding his share of the business and Morty feeling that the valuation is unfair.

• With an Agreement: The partnership agreement could lay out the rules of the road for a withdrawal. Is it a buy out? Is it structured? What are the terms of the buyout? How will you determine the value of the equity? These are all things that can be decided early while you are still playing nice in the sandbox.
• Without an Agreement: The TBOC has provisions for the withdrawal of a partner from a partnership. They are pretty basic, it is considered a redemption and the fair market value of the equity has to be paid within a certain amount of time following the demand of the withdrawing partner. Any structured payments would have to be agreed upon by the partners. There may also be a battle of determining the fair market value of the equity of the withdrawing partner. This confusion could be avoided by agreeing to the terms of the withdrawal ahead of time.

Starting a business is an exciting endeavor, but it’s crucial to lay a strong foundation with a comprehensive Operating or Partnership Agreement. This document not only protects your business but also helps prevent disputes that could lead to lawsuits. By addressing key issues like ownership, decision-making, capital contributions, profits, death and disability, and partner changes, you can ensure your business runs smoothly and avoid unnecessary conflicts.

Don’t let the lack of an agreement become a stumbling block—take action now to secure your business’s future and avoid the courtroom.

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