Handshakes vs. Operating Agreements: The Case Against Running on Trust

What Is an Operating Agreement?

An operating agreement is the governing contract among the owners of a limited liability company: the document that sets out who owns what, who decides what, how money moves, and what happens when an owner leaves, dies, or stops performing. The New York Department of State describes it as “the primary document that establishes the rights, powers, duties, liabilities and obligations” of the members, both among themselves and with respect to the company. New York does not treat the document as optional. Section 417 of the Limited Liability Company Law commands that the members of every New York LLC “shall adopt a written operating agreement,” and it may be entered into before, at the time of, or within 90 days after the articles of organization are filed.

The agreement is an internal document. It is never filed with the state, no agency reviews it, and the Department of State concedes that the law is silent on the consequences of failing to adopt one. That silence is exactly where the trouble lives. Nothing forces a founding team to write the contract, and the penalty for skipping it arrives years later, in the form of a dispute governed by rules nobody in the room ever chose.

The Trust Paradox: Why Founders Skip the Document They Need Most

Founders skip the operating agreement precisely because they trust each other. The people starting a business together want to go full force into the work, and the last thing they want to do is sit across from a partner they believe in and negotiate every possible falling out. It feels like planning the divorce during the honeymoon. So the terms get made on the fly, and each partner quietly assumes the others share expectations that were never spoken.

The research says trust is not protection. Harvard Business School professor Noam Wasserman, who studied thousands of founders for The Founder’s Dilemmas, found that people problems rather than product problems account for roughly 65% of the failures among high-potential startups. The figure is a share of the failures, not a failure rate: among the ventures that do fail, most fail over the relationships among the founders rather than over the product or the market. His research produced a second finding that should unsettle every family business and every pair of best friends with a company: founding teams built from friends and family proved among the most fragile, because they avoided tough conversations to spare feelings. The teams most confident they do not need the hard conversation are often the ones that need it most.

Every founding team already has an operating agreement. It is simply unwritten, and each founder carries a different version of it in their head: who works how many hours, who controls the money, whose vote breaks the tie, what happens if someone wants out. The written agreement does not create those terms; it surfaces the conflicts between the versions before they become fights. The negotiation itself is where the clarity comes from. After the tough debates, each partner knows exactly what the business needs, what each side contributes, and what is expected. And the timing matters: the cheapest moment to negotiate is at formation, when the counterparty likes the deal, wants it to work, and is being reasonable, not years later, when the counterparty is angry and represented by counsel. Some partnerships end at the drafting table, and that is the agreement doing its job before it is even signed.

Silence Is Not Neutral: The Default Rules Are a Contract Somebody Else Wrote

An LLC without an operating agreement does not operate without rules. It operates under the default rules of the Limited Liability Company Law, a one-size-fits-all statute written for every business in the state and tailored to none. Nearly every default provision opens with the phrase “except as provided in the operating agreement,” which means the Legislature expected owners to write their own terms and supplied a fallback for those who did not. Founders who never write the agreement have not avoided a contract; they have accepted one, unread.

Voting Power Follows the Statute, Not the Founders’ Understanding

Under Limited Liability Company Law § 402, absent a contrary operating agreement, each member votes in proportion to that member’s share of current profits, and a bare majority in interest can admit new members, take on extraordinary debt, amend the operating agreement itself, sell substantially all of the company’s assets, merge the company, or dissolve it. In an LLC with five equal members, three of them can do all of that without the consent, or even the knowledge in advance, of the other two. Supermajority requirements, unanimous consent for major decisions, and minority vetoes are common and sensible protections, and not one of them exists unless it is written down.

Nobody Can Leave, and an Unplanned Exit Can Drain the Company

The exit rules are harsher than most owners expect. Under Limited Liability Company Law § 606, unless the operating agreement provides otherwise, a member may not withdraw at all “prior to the dissolution and winding up” of the company. A partner who wants out is statutorily locked in, with no right to resign and no right to be bought out. The mirror-image danger is just as bad, and it comes from a different section: where the operating agreement does permit withdrawal but does not spell out its terms, Limited Liability Company Law § 509 entitles the departing member to the fair value of the membership interest, within a reasonable time after withdrawal. That is a cash obligation of unplanned size, on an unplanned schedule, that can land on the company at the worst possible moment. A drafted agreement replaces both traps with a designed exit: notice periods, valuation formulas, and payment terms the business can actually survive.

Death, Divorce, Departure: The Membership Interest Outlives the Partnership

A partner’s equity does not disappear when the partner does. It goes somewhere: to an estate, to an ex-spouse, to a buyer, or it sits with a cofounder who checked out years ago and still owns 40% of the company. The default rules make every one of those outcomes awkward. Under Limited Liability Company Law § 603, an assignment of a membership interest transfers economic rights only: the assignee collects distributions and profit allocations but gains no right to participate in management and does not become a member. And under the companion default rule, an assignee, including one who inherits a deceased member’s interest, is not admitted to membership unless the remaining members consent. The result is a company whose profits flow indefinitely to an outsider with no vote, no duties, and no reason to care whether the business thrives, while the people running it gained a silent financial partner they never chose.

Death has its own regime, and recent case law has made it more potent. Limited Liability Company Law § 608 authorizes a deceased member’s executor or other legal representative to exercise all of the member’s rights “for the purpose of settling his or her estate,” and New York’s appellate courts have recently read that as real voting power in the hands of the estate: the right to inspect books and records, the right to vote the deceased member’s interest, even the right to continue a dissolution proceeding the member began before dying. Surviving owners who assumed they would simply carry on can instead find themselves negotiating company decisions with an executor, or with a widow, or with the co-executors of a partner’s contested estate. Buy-sell provisions triggered by death, divorce, disability, and departure, with a valuation formula, a funding source such as insurance, and a timeline, are the only mechanism that converts those events from governance crises into transactions.

Deadlock Ends in Court, and the Court May Not Help

Two 50/50 owners who stop agreeing can freeze a company solid: no hiring, no lease renewal, no financing, no direction. Owners tend to assume that if things get bad enough, a judge will step in and unwind the business. In New York, that assumption is wrong more often than it is right. Judicial dissolution is available only where it is “not reasonably practicable to carry on the business” in conformity with the articles of organization or the operating agreement, and in Matter of 1545 Ocean Avenue, LLC, 72 A.D.3d 121 (2d Dep’t 2010), the Appellate Division held that deadlock, which is an independent statutory ground for dissolving an ordinary corporation, is not an independent ground for dissolving an LLC. The analysis is contract-based: the court looks first to the operating agreement, and dissolution is a drastic remedy reserved for a company that cannot achieve its stated purpose or is financially unfeasible. In 1545 Ocean Avenue itself, the operating agreement allowed each managing member to act unilaterally in furtherance of the company’s purpose, and that drafting choice defeated the dissolution petition. The document decided the case.

Practitioners who litigate these disputes for a living have drawn the obvious conclusion: in the many two-member, 50/50 LLCs with no operating agreement or one lacking any deadlock-breaking mechanism, the courts’ equitable powers are hobbled, and the owners are left in a stalemate the law will not resolve for them. The tiebreaker has to be built in advance. A designated deciding vote on defined matters, mandatory mediation triggers, and buy-sell or shotgun provisions convert a stalemate into a transaction: one side names a price, the other buys or sells. Without those clauses, deadlock ends in years of litigation over a statute that was never designed to rescue the deadlocked, and the business is usually the casualty either way.

The Agreement Protects the Liability Shield Itself

The limited liability that owners form an LLC to obtain is not unconditional. New York courts will pierce the veil and reach the owners’ personal assets where, under the standard of Matter of Morris v. New York State Department of Taxation and Finance, 82 N.Y.2d 135 (1993), the owners exercised complete domination over the entity and used that domination to commit a fraud or wrong that injured the plaintiff. Among the factors New York courts weigh in that analysis are the failure to adhere to corporate formalities, inadequate capitalization, commingling of assets, and the use of company funds for personal benefit. An LLC with no operating agreement, no documented governance, and no observed distinction between the company’s money and the owners’ money looks less like a separate legal entity and more like its owners’ alter ego. A written operating agreement, followed in practice, is standing evidence that the company is real, separately governed, and entitled to the shield its owners formed it for. Skipping the document does not just create risk between the partners; it weakens the wall between the business and everything the partners own.

The Money Questions the Statute Does Not Answer

Some of the most common founder blowups involve questions the Limited Liability Company Law does not address at all. The statute has no concept of sweat equity or vesting. When one partner contributes money and the other contributes time, the money partner tends to believe the equity was bought outright, and the working partner tends to believe it is being earned; eighteen months later, when the working partner slows down or walks away with a full share intact, both discover the disagreement at once. Vesting schedules and written contribution obligations, standard tools in any competent operating agreement, resolve that conflict before it exists. The statute is equally silent on capital calls. When the business needs money and one partner can write the check while the other cannot, does the contributing partner get diluted equity, a loan, or nothing? Whatever the answer, only the operating agreement can supply it, and supplying it in advance prevents the funded partner from squeezing out the unfunded one, and the unfunded partner from free-riding on the funded one.

Then there is the tax arithmetic, which surprises owners every April. An LLC taxed as a partnership pays no federal income tax itself; under the rules collected in IRS Publication 541, its income passes through to the owners. And under Internal Revenue Code § 702(a), each owner is taxed on the full distributive share of that income whether or not it is ever distributed. A member can owe real tax on paper profits that never arrived, because the majority preferred to reinvest every dollar. A tax-distribution clause, requiring the company to distribute at least enough cash to cover each member’s tax on allocated income, is a single paragraph that prevents one partner’s growth strategy from becoming another partner’s insolvency. The same section of the agreement settles the perennial fight between the partner who wants to pull profits to live on and the partner who wants to reinvest everything: both positions are reasonable, and left undefined, they produce a war every fiscal year.

Conclusion

The case for the operating agreement is made by the authorities themselves: a statute that commands every New York LLC to adopt one in writing; default rules on voting, exit, assignment, and death that almost no founding team would choose on purpose; an appellate standard that makes judicial rescue from deadlock the rare exception rather than the rule; a veil-piercing doctrine that rewards documented, observed governance; and a tax code that taxes owners on money they may never see. The negotiation is not a tax on the friendship. It is the founding team’s first real planning session, and the clarity it produces about contributions, expectations, control, and money is worth as much as the paper it ends up on. A good operating agreement is a recipe for a great business. A great operating agreement is both shield and sword: a shield against a partner’s worst day, and a sword that lets the company act decisively on its best one. The best of them are never opened again, not because they did not matter, but because writing them forced every hard conversation to happen at the beginning, while everyone was still on the same side of the table.