When forming an LLC, businesses take great pains to file the appropriate documents and pay the necessary fees to their states of operation. However, one crucial document that isn't required should still always be included whenever you found an LLC: the Operating Agreement.
What is an Operating Agreement?
In brief, an Operating Agreement is a critical document used by limited liability companies or LLCs. This document outlines and describes many of the major attributes or focuses of a given LLC, particularly relating to its functional and financial decisions and frameworks.
For example, an Operating Agreement may outline:
- Who owns the business
- What the business's purpose is
- How profits are distributed or split
- What to do if a new member is brought on or a member is removed
- And so on
Unlike other documents, Operating Agreements are not filed with your state's business department when you form an LLC. Instead, the Operating Agreement is kept with other critical business documents for future reference and to ensure that the business is governed or run in a way that suits each member's needs.
Why Do You Need an Operating Agreement?
There are multiple reasons why LLCs must draw up and agree upon an Operating Agreement.
Protect Your Business's Limited Liability Status
For starters, Operating Agreements can protect the business's limited liability status. The point of an LLC is to limit the liability of individual members from business debt or other issues. Having an Operating Agreement that spells out this purpose in ink can protect you and other members in the event of bankruptcy or another financial problem. Without Operating Agreements, LLCs can too closely resemble partnerships or sole proprietorships, which can lead to trouble if you're ever taken to court.
Protect Agreement in the Eyes of the State
Perhaps more importantly, Operating Agreements protect your operational terms in the eyes of the state. If you don't have an Operating Agreement, default state business rules will govern your LLC's operation instead, which can lead to trouble later down the road or which might not serve the needs of your unique business.
Clarify Verbal Agreements
Furthermore, Operating Agreements clarify verbal agreements between members. Having the terms of the LLC, such as how profit is distributed and who's in charge of the business's hierarchy, outlined in writing minimizes the likelihood of misunderstandings.
As touched on above, Operating Agreements allow you to customize your business's structure much greater than the general rules outlined by your state's business department. This allows you to tailor the LLC to better suit the needs of your members, business model, and even your customers or clients.
One last niche benefit is that it protects the company in the event that two or more married members in the LLC file for divorce. If members are married and jointly own at least part of an LLC, an Operating Agreement can prevent the company from fracturing when assets are divvied up in court.
Information to Include in an Operating Agreement
As you can see, it's a great idea to include an Operating Agreement when starting your LLC. Here are some of the key pieces of information you'll need to include to make sure you have an airtight document.
You'll always need to describe which members are involved with the LLC and what level of ownership each member has. For instance, the company's founder may have the largest level of ownership compared to other members, but the rest of the members combined may have a majority of ownership and be able to outvote the founder in cases of extreme disagreement.
Whatever the case for your company, be sure to specify these arrangements so no disagreements regarding ownership come up in the future.
Perhaps most importantly, your Operating Agreement should describe the profit distributions for each member, as well as key employees or workers. The profit distributions of your company are of key concern since they prevent certain members from taking more than their fair share, especially since all the members of an LLC must agree on the profit distribution before the Operating Agreement is legitimate.
Most Operating Agreements founded on more democratic principles will include voting rights rules. These outline when votes are allowed to be made on company decisions, such as expansions or mergers. Furthermore, the Operating Agreement can describe who is allowed to vote, how much each vote counts (for instance, does each member get one vote of equal weight?), and so on.
Furthermore, your Operating Agreement should outline the specific responsibilities (and, thus, liability) of each member in detail. Again, this prevents any disagreements surrounding responsibility or blame – everyone knows exactly what the job of everyone else is and who's responsible for what in the company.
Procedures for Transferring Interest
Your Operating Agreement can provide some guidelines if interest or ownership must be transferred from one member to another. For instance, if a business owner or member dies, the Operating Agreement should describe in detail where that member's interest and ownership goes, as well as lines of succession.
Many businesses distribute shares of ownership of the company to members or owners. Operating Agreements can describe whether the distributive shares of each member correspond to their ownership in the LLC or if it follows a different format for structure. This is a particularly important piece of the Operating Agreement if your LLC is on the stock market.
How to Create an LLC Operating Agreement
As seen with the above information, creating an LLC Operating Agreement is a complex affair. That's why it's often helpful to have a lawyer present during the drafting meetings and when all the members sign the document to agree on its terms.
A lawyer can look over your Operating Agreement, check it for any loopholes or weak links, and confirm that each member fully understands the terms and conditions of the agreement before they sign. This results in a much more secure and stable document that you can rely on for the rest of your business's lifespan.