What Do LLCs Need to Know About Operating Agreements?
What comes next after an entrepreneur forms an LLC for their startup? Small business owners may prioritize registering for a trademark or filing for an employer identification number (EIN) next. If you already have obtained these assets, it’s time to look into preparing an operating agreement for your business.
What’s An Operating Agreement?
An operating agreement is a document that defines how an LLC is run. Depending on the type of LLC you incorporate as, which can range from single member to member-managed, you may wonder if there’s a need to create this kind of written document. After all, isn’t it possible for an LLC to simply follow spoken rules?
Yes and no. What an operating agreement does is cement the company’s LLC status in the eyes of the state. An operating agreement is a legally binding document that ensures the LLC is conducted in the manner you see fit, protects your personal liability, and has an understanding of how to deal with business issues, such as member disputes. If something unforeseen should happen and your LLC is taken to court, having a written operating agreement will be a much more credible, legitimate source of information over an oral agreement.
What Goes Into An Operating Agreement?
One of the most daunting aspects of writing an operating agreement can be attempting to figure out what all goes in its contents. Let’s quickly recap a few key areas to cover in your LLC’s operating agreement.
Ownership. This outlines the percentage of the LLC’s profits, losses, and assets that each member of the LLC is entitled to receive. Determining ownership percentages is often dictated on the LLC’s structure. For example, a single member LLC only has one member acting as the owner. They would receive 100% of the LLC’s profits, losses, and assets. However, this is not the case for all small businesses. Ownership rights may vary, depending on what the owners feel they are entitled to receive, so a discussion must be held to determine how these profits, losses, and assets will be divided among the LLC’s owners.
Members’ rights and responsibilities. Simply put, an operating agreement must outline a division of labor. This ensures each member understands their role and duties in the LLC. Additional details to highlight include plans for settling member disputes and how much of a say each member has in business decisions.
Joining and leaving the LLC. The operating agreement must have a plan in place for what happens if a member decides to leave the LLC or if the owners consider bringing on a new member. Check in with your state to see if there are specific rules to follow. For example, some states may call for the LLC to automatically dissolve if an initial member leaves the entity. The process for bringing on new members should outline incentives the new members receive for joining the LLC. It should also cover how their initial investment determines their ownership of the LLC’s existing profits, losses, and assets.
Dissolution. It’s never easy to discuss, but procedures must be in place for an LLC’s dissolution. If the business dissolves, the operating agreement will outline how to divide its assets after the entity has repaid its debts.
Severability provision. A severability provision wraps up an operating agreement. What this standard boilerplate does is state that, in the event a provision of the operating agreement goes against the grain of state law, all other aspects that are not contrary to the law will remain in effect.
Does An LLC Need A Written Operating Agreement If It Isn’t A State Requirement?
It’s true. Many states do not legally require LLC formations to have a written operating agreement. This tends to be the biggest reason why entrepreneurs overlook, or decide to skip over entirely, drafting an operating agreement. If the state doesn’t require it, why go to all the trouble to write and document one for the LLC.
However, I strongly make the argument in favor of having a written operating agreement for an LLC. Look at all of the great benefits that come with having a written operating agreement instead of relying on an oral agreement. A written operating agreement gives your LLC structure, defines the roles and responsibilities of its members, and outlines regulations for necessary business procedures. These may otherwise fall through the cracks in spoken agreements. Having a written operating agreement, and distributing said agreement out to its members, is necessary to ensuring the overall success of the LLC in the short and long run.
