The Elephant in the Room
The Absence of an Operating Agreement
An operating agreement is critically important because it directs how a business and its finances should be handled in the event of the owners’ death or inability to communicate. This clear failure to plan can leave your business - and your loved ones - vulnerable. An operating agreement works essentially like a buy-sell agreement (for companies with partners). And both documents need an up-to-date business valuation and, hopefully, an intelligent funding mechanism.
Every Business Owner Needs One
An operating agreement is a legal document that outlines how your business operates and what should happen if you’re no longer able to manage it. While it’s more commonly associated with multi-owner businesses like LLCs, it’s just as valuable for sole proprietors. It can include:
Management Instructions: Who takes over daily operations if you’re incapacitated?
Financial Directives: How are profits, debts, expenses… managed in your absence?
Succession Plans: Should the business be sold, transferred or shut down?
Decision-Making Authority: Who has the power to decide any of this?
There are no mind readers on the planet. Whatever you were thinking may end up trapped in your head or follow you to the grave.
Is There Anything More Important Than Control
Every business owner started their enterprise because they wanted control. So why would they instantly give it up in the wake of an unforeseen event? As a sole proprietor, your business is "you". If you die or become unable to communicate, there’s no automatic system to keep it running or wind it down. Here’s some of the potential ripple effect:
Log-ins and Passwords: Accounts... what are they, where are they, and how are they accessed?
Chaos: If no one knows who’s authorized (qualified) to manage your business… family, employees, clients, and creditors could be left in limbo.
Probate: If you pass away, your business assets might get stuck in probate, halting operations and draining value.
Family Burden: Loved ones may end up in disputes or unintended outcomes like a “fire sale”.
An operating agreement provides clarity and control, ensuring your business continues or closes according to your plan.
The Bigger Picture: “I Don’t Need Any of this. I Don’t Have a Partner”
Many sole proprietors assume that buy-sell agreements, business valuations, and funding mechanisms are exclusive to businesses with multiple owners. That is short-sighted.
Buy-Sell Agreement
You might think, “I don’t have a partner to buy me out, so why bother?” A buy-sell agreement isn’t just for co-owners. It can be set up with a key employee, family member, or third party. It ensures your business is transferred or sold smoothly if you die or become incapacitated, avoiding a potential trainwreck – emotionally and financially for those left behind.
Business Valuation
Knowing your business’s worth isn’t just for selling to a buyer. A valuation helps with:
Estate Planning: Accurate value prevents tax overpayments or disputes with heirs.
Insurance: You’ll know how much life or disability coverage makes sense.
Exit Planning: If the business must be sold, an objective valuation ensures fair pricing.
Funding Mechanism
Properly designed life and disability insurance can provide time and options. It will:
Give family members some ability to deal with the emotional impact.
Provide cash to keep the business operational and assign new management.
Pay off debts and/or taxes.
Compensate heirs without forcing a sale.
Sole proprietors who neglect this might leave their families in chaos with no resources to manage or transition the business.
Where to Begin
You don’t need to be a legal expert to get started, but you should never go it alone. There is too much at risk. Too many variables. A team of experienced advisors could be your best bet:
Find a Lawyer You Trust: They’ll ensure your agreement reflects your intentions and complies with any applicable laws.
Consult with Your Financial Advisor, CPA: They can tie in valuations and provide options for insurance, tax implications, etc.
Update Your Documents Regularly: This applies to all agreements: wills, valuations, estate plans...
DISCLAIMER: I AM NOT A LAWYER AND I HAVE ZERO LEGAL TRAINING
What I do have is 30 years of real-world experience, and there is no shortage of “war stories” when it comes to Small Business and the immediate impact of an unforeseen event.
I strongly suggest you consult with a team of qualified professionals to discuss this topic and explore intelligent next steps. There are common mistakes business owners make. But most can be corrected with proper planning.
Elephants are large and carry a lot of weight. So are some mistakes business owners fail to correct.