India: Operating Agreements – Relevance For A Start-Up Venture

Introduction

An operating agreement is an important piece of document as it not only outlines the financial and functional decisions of a business including rules, regulations and provisions but also the contractual relationships at the helm of affairs.

The purpose of an operating agreement is to lay governance of the internal operations of a business in a manner that is in tandem with the specific needs of the business owners. Once signed by interested parties, it acts as an official contract binding them to its terms. An operating agreement is highly recommended for multi-member business ventures because it channelizes and structures such venture's resources, functions, finances and organization, and renders governing rules for smooth operation of the business. Main components in an operating agreement generally include percentage of interests, allocation of profits and losses, member's rights and responsibilities etc. Accordingly, operating agreements for a start-up venture are devised to protect the rights & interests parties creating such business venture with the aim to dwindle personal liability and mitigate legal impediments.

Key issues dealt with under a start -up operating agreement

  • Finances (capital contribution25),
  • Business procedures,
  • Operating structures and ownership percentages,
  • Voting rights,
  • Roles, responsibilities and operating procedures
  • Individual / functional responsibilities,
  • Powers and duties,
  • Profit distribution,
  • Loss distribution,
  • Confidentiality,
  • IPR
  • Meeting schedule,
  • Termination & consequences,
  • Buyout stipulations,
  • Buy-sell rules, etc.

It is not necessary that an operating agreement has to run into thousands of pages; however, it must be meticulously drafted to comprehensively incorporate the understanding of the interested parties qua above note issues. The length and complexity of an operating agreement is subject to size of business, plan, and industry. As rightly said, the more you sweat in peace, the less you bleed in war. Therefore, while drafting an operating agreement, the document needs to define the stake holder's roles, responsibilities and operating procedures.

Case study: In September 2016, a bitter, year-and-ahalf- long lawsuit between the founders of Snapchat finally came to a close. Business Insider reported that co-founder Reggie Brown, who came up with the concept for the timed photo-sharing app but wasn't given equity for his work, received a settlement from the two co-founders who ousted him from their startup. Had the Snapchat team set up an operating agreement prior to launch, they might have been able to avoid this costly legal snafu.26

It is to be borne in mind that certain documents (core legal documents) are of paramount importance and must be in place for a start-up venture, namely:

1. Operating Agreement (Founder's Agreement): To avoid any conflict among founding parties, all co-founders should sign a comprehensive operating agreement. The agreement should define the relationship of the founders and should narrate the expectation that all work will belong to some entity in the future; accordingly outline a basic communication and conflict-resolution clause that can help prevent disputes;

2. Bylaws: These are internal rules of the venture and may include policy framework regarding issues such as disputes settlement, leadership selection & determination of rights/powers of shareholders, voting rights etc.;

3. Articles of Incorporation: this document is to detail the business structure;

4. Intellectual Property (IP) Assignment Agreement: For devising guiding principles for valuation, ownership, assignment of IP assets/ portfolio. There could be two types of IP assignment agreements to consider: (i) Technology Assignment Agreements assign startups any intellectual property created before forming the company. Developers may in certain instances retain individual IP ownership rights, or they may sell their rights in exchange for equity or cash; and (ii) Invention Assignment Agreements assign the new company IP ownership of any relevant work product created by employees after the company's formation. A confidentiality and invention assignment agreement is typically signed by founder(s) and employees. The venture should own all rights to the IP portfolio;

5. Non-Disclosure Agreements: To protect startup venture by safeguarding founders and employees' ideas and intellectual property. An NDA should specify the following: definition of confidential information, handling of confidential information, ownership of such information (the company), disclosure, time period for which confidentiality will be maintained, etc.

6. Employee Contracts and Offer Letters: For recording terms of employment (e.g., compensation, role responsibilities, working hours and grounds for termination), reporting structure, IP ownership of work, expectations, required commitments, share vesting, adherence to company policies (e.g., vacation days, paid time off structure, dress code), etc.

7. Shareholder Agreements: For determining (when there is private investment into the venture), the rights of shareholders including right to transfer shares, right of first refusal, redemption upon death or disability and shareholders' power to manage and run the startup venture etc.

It is highly recommended that terms relating to owner contributions; capital accounts; allocations of profits; losses and distributions; membership rights and voting with respect to matters affecting the company; management; disposition of ownership interest in the company in various instances; and other potential ownership-related disputes and circumstances are incorporated in the operating agreements. Be that as it may, in case the business operations have already commenced, it is never too late to put in place an operating agreement with retrospective effect. Also the owners / stakeholders need to explore possible future scenarios and establish procedure that should settle probable unwanted situations in a reasonable manner if they occur.

Footnotes

25 Capital can take the form of cash, property, both tangible and intangible, as well as services. It is extremely important to have a record of who contributed what on day one.

26 http://www.businessinsider.in/The-alleged-betrayaldescribed-in-these-photos-texts-and-emails-cost-Snapchat-158-million/articleshow/56955306.cms

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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