Starting a small business is an exciting venture, and setting the right foundation is crucial. For many small business owners, this involves forming a Limited Liability Company (LLC) and creating an operating agreement to shield themselves from personal liability, legal burdens, and financial obligations. This article provides a detailed explanation of What Is An Operating Agreement, its key components, benefits, and how to create one for your LLC.
Operating Agreement: Defined
An operating agreement is a fundamental legal document that outlines the structure, management, decision-making processes, and operational procedures of an LLC. Think of it as a blueprint for how your LLC will function. Once signed, it becomes a binding contract between the LLC members.
Key Inclusions of an Operating Agreement
An operating agreement meticulously defines a company’s operational and financial rules. It serves as a practical guide on how the business should be run and managed. The agreement typically covers the following essential elements:
- Ownership Percentages: The portion of each member’s ownership in the LLC, usually expressed as a percentage.
- Powers and Duties: Clearly defines the roles, responsibilities, and authority of managers and members.
- Profit and Loss Distribution: Specifies how profits and losses will be allocated among the members.
- Member Duties and Benefits: Outlines the obligations and advantages each member is entitled to.
- Meeting Procedures: Describes how board member meetings will be conducted and how decisions will be made.
- Admission of New Members: Explains the process for admitting new members into the LLC.
- Voting Rights: Details the voting rights of each member on important decisions.
- Buyout and Sellout Processes: Defines the procedures for ownership transitions, including buyouts and sellouts.
- Tax Considerations: Addresses the tax implications for the LLC and its members.
- Transfer Provisions: Specifies the rules and limitations on transferring ownership interests.
The more comprehensive and specific the operating agreement, the better it serves the LLC. A well-drafted agreement balances formal structure with the flexibility needed for a specific LLC to thrive.
Pros and Cons of Operating Agreements
The advantages of having an operating agreement significantly outweigh the disadvantages:
Pros:
- Liability Protection: Shields LLC members from the debts and liabilities of the LLC itself.
- Clarity: Provides clear guidelines for the structure and operation of the LLC, minimizing misunderstandings.
- Flexibility: Allows for customization to suit the specific needs of the LLC.
Cons:
- Expense: Developing an operating agreement can incur some costs.
- Increased Formality: Introduces a level of formality to the business operations.
- Administrative Duties: May require additional administrative tasks for updates and amendments.
Benefits of an Operating Agreement
The main benefits of having an operating agreement include:
- Protecting Members from Liability: Without an operating agreement, an LLC could be viewed as a sole proprietorship, exposing the owner’s personal assets to business debts.
- Establishing Clarity: A clear operating agreement ensures everyone understands the rules, streamlining decision-making and reducing potential disputes.
- Providing Customization: Operating agreements can be tailored to the specific needs of the LLC, rather than being forced to comply with generic rules.
- Avoiding Default Rules: Without a signed agreement, the state’s default rules may govern the LLC, potentially leading to unfavorable outcomes.
While the downsides are minimal, it’s important to acknowledge them:
- Extra Expense: Creating an operating agreement requires an investment, though it’s often considered a worthwhile cost.
- Perceived Constraints: Some entrepreneurs may resist the formality of an operating agreement, preferring less structured arrangements. However, written agreements are crucial.
- Increased Formality: The formalities and requirements of an operating agreement may require extra effort for amendments and updates.
Operating Agreement vs. Bylaws and Certificate of Formation
It’s important to distinguish an operating agreement from other important business documents:
Operating Agreements vs. Bylaws
Operating agreements and corporate bylaws are not the same. While there are parallels, they govern different types of organizations:
- Operating Agreements: For LLCs, focusing on ownership, management, and financial matters.
- Bylaws: For corporations, governing internal operations, management, and interactions with members, shareholders, and directors. Bylaws tend to be more rigid.
Operating Agreements vs. Certificate of Formation
A certificate of formation (also known as articles of organization) is a legal document filed with the state to officially form the LLC.
- Certificate of Formation: A public document containing basic information like business name, purpose, management structure, and registered agent.
- Operating Agreement: An internal document not legally required and not made public, detailing the LLC’s operating procedures.
Do You Need an Operating Agreement?
While not legally required in all states, an operating agreement is highly recommended for all LLCs. Some states, including California, Delaware, Maine, Missouri, and New York, require a written operating agreement. Here’s why it’s essential:
- Enhanced Clarity: Provides a clear understanding of roles, responsibilities, and expectations for all members.
- Reduced Potential for Friction: Serves as a neutral reference point to minimize disagreements among co-owners.
- Increased Liability Protection: Reinforces the LLC’s status as a separate legal entity, protecting members from personal liability.
The ideal time to create an operating agreement is during the LLC’s formation. While it can be created later, establishing clear procedures from the outset simplifies business operations.
Single-Member LLCs
Even for single-member LLCs, an operating agreement is crucial. It reinforces the separation between the owner and the business, preventing it from being viewed as a sole proprietorship.
Formal Steps for Setting Up an Operating Agreement
- Notarization: Not usually legally required, but recommended for added validity.
- Filing with the State: Not required for operating agreements, but certificates of formation must be filed.
- Public Record: Operating agreements are not public records and should be kept confidential.
Creating an Operating Agreement
There are several ways to create an operating agreement:
- Self-Drafting: Requires knowledge of business law and experience in drafting operating agreements. Legal review is essential.
- Hiring a Lawyer: Offers professional guidance and ensures the agreement is legally sound.
- Using a Template: Can be a starting point, but requires careful customization and legal review.
5 Easy Steps to Set Up an LLC Operating Agreement
- Learn Your Jurisdiction’s Requirements: Understand any state-specific requirements for operating agreements.
- Gather Essential Information: Collect details about the LLC, including owners, contributions, and ownership percentages.
- Create a Blueprint of Structure and Rules: Define ownership, management structure, profit allocation, and decision-making procedures.
- Address Key Provisions: Cover capital contributions, profit distribution, member addition/removal, dispute resolution, and dissolution procedures.
- Sign and Keep Copies: Have all members review and sign the agreement. Keep copies for reference and legal protection.
Conclusion
An operating agreement is a valuable tool for any LLC. It protects members from personal liability, clarifies relationships, and guides the LLC towards success. Taking the time to create a comprehensive and well-drafted agreement is a wise investment in the future of your business.
Additional LLC Operating Agreement Resources
- Practical Law’s startups and small businesses collection: Resources for hiring, funding, and scaling your business.
- An LLC Operating Agreement Checklist: A checklist of questions to consider before preparing an LLC agreement.
- LLC Operating Agreements Line by Line: A comprehensive explanation of the material provisions and issues in LLC operating agreements.
- Structuring and Drafting Partnership and LLC Agreements, Fourth Edition: Expert guidance on crafting tax-driven agreements for partnerships and LLCs.
- Limited Liability Companies: Law, Practice, and Forms, 2d: A resource optimizing the flexibility and tax advantages of LLCs and helps analyze planning issues.
