Congratulations! You have decided to form a limited liability company (LLC) to run your business. Now what? After formally registering with your state (usually by filing Articles of Organization), your LLC needs to have the right documentation in place. The first document you’ll need is an operating agreement. This is the document that describes and outlines how your LLC will run. If that sounds important, it is. Although most states don’t require you to have an operating agreement, they are an essential component of running your business. Here are five reasons why you need one:
- Customize how your business operates.
A key advantage of LLCs is the ability to create flexible business structures. But without an operating agreement, your business can’t take advantage of that flexibility and will instead be subject to the default rules set out in your state’s LLC statute. On the other hand, if you draft an operating agreement, you can customize a variety of provisions related to the management and ownership of your business including:
- how profits and losses are split among members;
- restrictions on the transfer of ownership interests;
- methods for paying business taxes; and
- signatories for business accounts.
This is not an exhaustive list. In general, unless specifically prohibited by your state’s LLC statute, most aspects of an LLC can be designed to reflect the members’ desires.
- It can help maintain members’ limited liability.
An important benefit of LLCs is that LLC members have limited liability—that is, they will not be held liable for the LLC’s obligations. However, that limited liability can be lost if steps are not taken to maintain the business as an entity that is separate from its owners. One practical way to do that is to create and implement an operating agreement. If your company ever gets sued, evidence that your LLC adheres to an operating agreement is one factor courts consider in determining whether it should be stripped of its limited liability protection. Clarifying the legal separation between business and owner is especially crucial for single-member LLCs, because the limited liability veil is more easily pierced when there is only one member. In those situations, intentional planning, including the drafting of an operating agreement, is necessary to strengthen the shield and preserve the limited liability of the member.
- Describe how decisions will be made.
Another critical part of the operating agreement is a provision that addresses how decisions are made. These clauses provide immense value, particularly for multimember LLCs and manager-managed LLCs, where several people may be involved in making management decisions. In those instances, it is vital to identify who has the power to make certain decisions. For example, if you have multiple LLC members, you may want to create two or more ownership classes with varying degrees of voting power. Or, if you have a manager-managed LLC, you may want to identify certain decisions that LLC managers are authorized to make while leaving other decisions for LLC members.
- Plan for contingencies.
One of the most important things your operating agreement can do is to help your LLC plan for and address contingencies. No one likes to plan how to end a relationship during the honeymoon phase, but it is critical for a business to have a plan from the outset. For instance, your operating agreement should address how matters like voting deadlocks will be resolved and whether/how members may be removed from the LLC. Will the LLC provide tie-breaking powers to specific managers or members in the LLC, or will they consult with an independent third party? What happens if a member retires, dies, or commits a breach of conduct? These issues should be addressed in your operating agreement.
- Often required by other institutions.
Even though most states do not require LLC operating agreements to be created or filed, others who work with your business may demand to see one. Some banks require a copy of the operating agreement before opening business accounts for an LLC. Potential investors would almost certainly demand to see a copy of your operating agreement when evaluating whether to invest in your business. It is essential to have an operating agreement in place to enable your LLC to take full advantage of business opportunities when they arise.
How We Can Help
We understand how to draft operating agreements that will help your business operate efficiently and avoid expensive litigation. Contact English & English for help creating or revising your operating agreement.