What is an Operating Agreement & When You Need One
An operating agreement is used by limited liability companies (LLC) to establish the operations of the business. This document is similar for an LLC and is very similar to by-laws that are used by legal corporations. Typically, the terms agreed to by members of the LLC are listed, including both day-to-day operating procedures as well as special circumstances.
If you’re ready to complete and file your LLC paperwork then you should also make sure you’re drafting your business agreement to outline the rules for members of the LLC. This can protect your liability and make sure all members are on the same page with operating procedures and are bound to them legally. My Company Works offers same-day LLC filing and we’ll provide you with the right operating document for your state as a one-stop-shop.
What is an Operating Agreement Used For?
This agreement is a legally binding document used by members of an LLC to outline contingencies with their legal relationship within the business. Without it, the owners of an LLC would be leaving to chance how a court wants to handle any potential future dispute amongst themselves.
If you have an LLC then it’s important to draft this document at the time of business formation. It’s not a legal requirement in most states, for an LLC to have an official agreement on file, but it is recommended by many legal experts so that your business operations are protected for your needs.
It’s also important for some companies to have procedures in place to borrow money in the future and to establish what happens if one of the members of the LLC gets a divorce.
How to Prepare an Operating Agreement
If you have never drafted business organizational documents, you may want to partner with an experienced company that operates in your state, or a local attorney, to make sure your agreement best fits your needs.
Information about your company and its members should be included. All the information needs to be spelled out in how the various LLC members and manager(s) work and interact together. There might also be some specific laws in your state that you’d like to moderate for your business by including specific rules. Some of the most common terms used to form these documents are discussed below.
Common Terms
The terms that apply to your business are unique, so it’s important to include information that applies directly to your business model. You should also include terms that will allow your business to operate differently than any state rules that don’t work for your business. For example, some states require all profits to be distributed equally, unless otherwise stated in your operating agreement.
Here’s a list of some of the most common terms you’ll want to think about working into your LLC’s operating document:
- Equity Structure & Membership Interest: Who owns the business and, typically, what percentage of the business does each LLC member own? The membership interest can be broken up into two different components: the economic and management interests. Technically someone who owns more management interest in the business could have full control of decision-making even if someone else owns more of an equity interest, though this typically isn’t the case.
- Rules for Allocation of Profits: There are basic rules for the allocation of profits, which is typically the rule that all profits are distributed evenly based on the percentage of ownership. However, you could alter this rule be defining how profits will be divided, based on management, responsibility, etc.
- Management Structure: With an LLC you can set it up where it’s managed by members of the LLC (owners) or by a manager. If your company will be run by a manager, you would need to define how that relationship will work in this section, so everyone is on the same page.
- Transferability: This section defines the rights and restrictions of LLC members to transfer their rights and ownership. You may enact veto rights by the other members in case a single member is trying to sell a large interest to an outside party that the rest of the members don’t want to operate with. You could also enact a right of first refusal in the event of a potential sale to allow the other members to potentially purchase the ownership interest instead of a sale to a third party.
- Buyout: This clause in the agreement would outline the rules behind certain buyout situations. For example, if a member of the LLC dies, divorces, or files for bankruptcy. The rules could stipulate that the company buys back the membership interest in any of those circumstances so that the other members don’t have to deal with an unexpected party.
- Dissolution: This stipulates the circumstances of how the LLC can be dissolved, typically by unanimous or a majority vote of the members.
- Records: This provision will dictate how and what records should be kept for the company, and often how long the records should be held. The most important part is to specifically point out the most important records that must be up to date at any given time.
- Forbidden Acts: This is an interesting provision that can actually restrict the members or managers of an LLC from specific acts, such as ones that would prevent the business from operating. Generally, the punishment for these acts will also be spelled out, such as an involuntary withdrawal from being a member of the LLC.
These rules are not a catch-all for what should be included in your organizational documents, but it should give you a good idea of what needs to go in yours. If you’re still not sure then you should contact legal counsel or an experienced company that helps businesses register LLCs.
When is an Operating Agreement Required?
The requirements vary greatly by state. Many states don’t require this type of agreement when you register an LLC, but some do. For example, Alabama, California, and Ohio all require you to have an documented arrangement if your LLC has more than a single member. This is contrary to other states like Colorado and Connecticut that require official agreements for single-member LLCs. If you’re not sure which state to incorporate in, these are the types of things you should be thinking about. Consider our guide on where to form an LLC.
If you choose not to draft and execute an legally-binding agreement, your business will be at the mercy of the state operating laws. This isn’t an ideal situation because you won’t be able to clearly define the operating procedures that are important to you and your business.
Even if your state doesn’t require one, it’s ideal for even single-member LLCs to establish an operating agreement that includes business operating procedures to fully establish your business. Doing so reduces the risk of being identified as a sole proprietor by the IRS. It also helps add separation between your personal and business liabilities.
Start an LLC and Operating Agreement
Even if your state doesn’t require you to have an operating agreement, it’s best to create one when you register your LLC. This is to make it clear how the operating procedures work within your business, even if you’re just a single-member LLC for now. These legally-binding documents can help protect your business from unfavorable laws or yourself by providing a shield of liability that the courts recognize. When you register your LLC at MyCompanyWorks, you’ll get an operating agreement for your state!