What to Know About Operating Agreements

No matter what kind of business you run, having an operating agreement is important. An operating agreement gives you a chance to explain how your LLC will function. This legal document isn’t required by the state to set up a limited liability company, but business experts all agree that creating this document before serving customers is ideal.  

We’ve put together some information about operating agreements. It explains what this document is and how to create one.

What is an LLC operating agreement?

An operating agreement includes the rules, policies, and regulations the company uses to make all of its business decisions. This includes both financial and functional decisions. 

Financial decisions would include things like how votes for investments will occur or dispersing profits. Functional decisions include the process for resolving disputes or handing business assets should the business be dissolved.

An operating agreement governs the business’ internal operations as the owners determine how the company should run. All LLC members must sign off on the operating agreement. By signing, they are agreeing to its terms and are bound to it as a legal contract.

It is an important document because it distinguishes the LLC from a sole proprietorship or partnership.

What are the benefits of having an operating agreement?

Protects each member personally

It’s like that every business will face some type of legal action eventually. An operating agreement protects each LLC member from someone filing against them personally for damages. 

Puts verbal agreements into writing

Members of the LLC may talk about how they want things to run in the business and could agree to operate a certain way. However, forgetfulness, miscommunication, and a misunderstanding could pop up and cause a disagreement among the members. 

Putting agreements into a formal, written contract like an operating agreement clarifies how things will be done. It forces the LLC members to discuss all aspects and agree to one way to do things. Future employees can refer to this contract for guidance on how to manage internal affairs the way the company has set up. 

Provides a blueprint on how to run your business

It creates a customized system for how the LLC will manage its affairs over time. This will become more important as years go by and the business grows. This will be incredibly important if the LLC chooses to open more locations or become a franchise.

Keeps the state out of your company’s affairs

As a safeguard, each state has a set of default rules that apply to LLCs that don’t draft an operating agreement. The state default rules are not the same state-to-state and can be incredibly general. Such boiler-plate default rules, which most LLCs have never seen, isn’t a good way to run a company and could hurt a business if the state actually imposed them.

Types of operating agreements

Multi-member LLC

This operating agreement is created for LLCs with more than one owner. It’s the sole document that establishes who the company owners are and ownership interest in the company. 

Multi-member operating agreements tend to be more complicated because they spell out what happens should a member die, who gets their percentage of company ownership in that event, or what would happen should a member face criminal charges whether the allegations involve the company or if the member is personally accused.

Single-member LLC

An operating agreement can be written for an LLC that is owned by one person. This type of agreement remains important because it separates the individual from the company to protect the small business owner from liability. It creates a legal distinction from a sole proprietorship.

It offers the same benefits and protection that a multi-member agreement would and keeps the state from interfering in the LLC’s daily business should a legal situation arise. 

Where is an operating agreement required?

States govern operating agreements because all LLCs are formed under state laws. Rules about operating agreements are different in every state. 

However, no state requires the owners of the LLC to file the operating agreement with the Secretary of State just as no state requires a company to file its bylaws in order to get approval as an official business. 

Each LLC member should have a copy of the operating agreement to keep in a safe place with all other business records. The original copy should be kept by the registered agent. 

It’s most used for your internal reference.

What should be included in an operating agreement?

  • Percentage of each LLC members’ ownership in the company.

  • Each members’ voting rights and responsibilities.

  • Members and managers duties and any powers that go with positions.

  • How profits and losses will be distributed.

  • Rules for holding future meetings, how often, when to hold emergency meetings.

  • Rules for buying out, selling, and transferring percentages. This includes the procedure of what happens should a death of an LLC member occur.

  • Legal name of the company, any fictitious or DBA names, and the company’s address.

  • Name and address of our registered agent.

  • Purpose of the business.

  • Statement of intent indicating the business entity conforms to state laws in forming the business.

  • Duration of the business allows it to continue indefinitely.

  • How the business will be treated for tax purposes.

  • Basic information about each member and each manager that includes job responsibilities.

  • Member contributions.

  • List of new members of an LLC, members’ rights and exit rights.

  • Dissolution process.

How to write an operating agreement

Below is a basic guide on how to write an operating agreement. However, most experts seek advice from an attorney, especially if it’s a multimember agreement. An operating agreement is a binding, legal contract, so it must address matters from a legal standpoint.

1. Start with the basic company information

This includes the company’s legal name, address, and information about the registered agent. 

2. Write out the business’ purpose

This is a short description of the industry and the product or service offered. There should also be a statement saying the business can participate in any lawful purpose under state laws. This protects the business if you change direction in your purpose later.

3. Write the statement of intent

A statement of intent declares the business will be created after all paperwork is filed with the state and that the business is formed and will operate under the laws of the state.

4. Set the duration of the startup

Typically, the business is set to run in perpetuity. However, some joint ventures may have a time limit such as when the project is completed.

5. List LLC member information

This information should include each person’s name, address, title, job responsibilities and ownership percentages. It should also show what each member contributed to the start of the business and any capital contributions. 

This can become important if each person contributes different things like knowledge versus money, equipment, real estate, or connections to a business deal. This section should be specific. 

6. List manager information

Some LLCs choose to operate with one person as the manager to run daily operations. If this is the case, all of the manager’s information should be listed just as you listed the LLC member information. If the manager receives a salary in lieu of a percentage of the business, that should be listed too.

7. State how meetings will be held

While there isn’t a law on when LLCs should hold meetings, the written operating agreement should list how many meetings should be held a year and when they will be. It should also state how emergency meetings will be called. You should also list how notices for meetings or other important company information is distributed.

8. Identify each member’s voting rights

Each LLC member has the right to vote at meetings. Some members who own a larger percentage may have more votes or veto power. You will also need to identify how votes are counted and whether a straight majority will rule in decisions. 

This is also the place to list a plan for dispute resolution.

9. Write out how the company will be taxed and member compensation

The two subjects are closely tied because how the company is taxed determines how members receive compensation. Filing as a corporation will mean each gets a salary while other forms of tax filings means each will get a share of the profits according to a distribution schedule.

10. Decide how new members and exit rights are handled

This outlines bringing on new LLC members and what happens if someone wants to leave the company. It also deals with transferring or buyout of percentages in the event of a member’s death. 

Special agreements should be identified. A special agreement lists how conflicts of interests would be handled, what constitutes conflict-of-interest and non-compete clauses.

11. Create a plan for dissolution

Just as you need a business plan, you also need a dissolution plan. This plan needs to be in place in case LLC members decide to end the business someday. A plan needs to include who files proper paperwork with the state and how aspects of the business from equipment to inventory will be handled.

FAQs

When do you create an operating agreement?

An operating agreement helps with decision-making and is often created right before filing Articles of Organization with state officials.

Can I write my own operating agreement?

Anyone can write their own operating agreement. If you need help, you can always look for an operating agreement template online. (There are many free LLC operating agreement templates online). However, it’s a good idea to have an attorney at a reputable law firm look it over. 

Do I need an operating agreement to open a business bank account?

You don’t need an operating agreement to open a bank account but some banks do require one, especially if there are several LLC members with access to the account or if you have a manager.

Is an LLC better than a sole proprietorship?

A sole proprietorship is good for a small or side business. It’s fast to set up and doesn’t have a management structure since it’s just you as the owner. 
An LLC protects your personal assets. It must be registered with the state, it impacts your income taxes with the IRS, and you must file an annual report.

How does an operating agreement protect you from liability?

Putting terms of the business in writing gives the business credibility as a separate entity, which is important when you deal with the legal system.

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