Operating Agreement: Definition and How to Create One
DD
Summary:
When you embark on a business venture, you’re often focused on the excitement of bringing your ideas to life and making a profit. While enthusiasm is essential, it’s equally crucial to establish a strong foundation that can safeguard your business and personal interests. This is where an operating agreement comes into play.
What is an operating agreement?
An operating agreement is a legal document that outlines the internal workings and structure of a limited liability company (LLC). It is a foundational document for LLCs, providing a roadmap for how the business will be run, the rights and responsibilities of its members, and how important decisions will be made.
Who needs an operating agreement?
An operating agreement is not just a nicety; it’s a necessity for LLCs. Whether you’re a solo entrepreneur or a group of co-founders, having an operating agreement in place can help avoid misunderstandings and conflicts down the road. Even if your state doesn’t require it, it’s a best practice to create one.
Differences from articles of incorporation
It’s essential to distinguish between an operating agreement and articles of incorporation. Articles of incorporation are filed with the state to officially create your business entity (e.g., LLC or corporation). On the other hand, an operating agreement is an internal document that outlines how your business operates and how it’s governed.
Why you need an operating agreement
Now that we’ve established what an operating agreement is, let’s delve into why it’s crucial for your business.
Protecting your business and personal assets
One of the primary reasons for having an operating agreement is to protect your personal assets from the liabilities of the business. Without an operating agreement, your LLC may be considered a sole proprietorship or a partnership by default, depending on the number of members. In such cases, your personal assets could be at risk in the event of lawsuits or debts incurred by the business.
By clearly defining the separation between your personal assets and the business’s assets, you create a legal barrier that shields your personal wealth from business-related liabilities. This separation is one of the key advantages of forming an LLC in the first place.
Clarifying ownership and management structure
An operating agreement lays out the ownership structure of your LLC, specifying each member’s ownership percentage. This is crucial not only for financial reasons but also for decision-making and management.
Without a clear operating agreement, disagreements about ownership stakes can arise, leading to disputes that can be costly and time-consuming to resolve. An operating agreement ensures that everyone is on the same page regarding ownership, reducing the potential for conflicts.
Resolving disputes
Disagreements among business partners or members are not uncommon. However, when they escalate, they can jeopardize the business’s stability. An operating agreement serves as a dispute resolution tool, providing a framework for resolving conflicts.
The agreement can include provisions on how disagreements should be handled, such as mediation or arbitration procedures. By having a predefined process in place, you can save time, money, and the relationships within your business.
What to include in your operating agreement
Now that you understand why having an operating agreement is crucial, let’s explore what elements you should include in it.
Ownership percentages and contributions
Specify the ownership percentages of each member and outline their initial capital contributions. This information is vital for determining each member’s share of profits and losses and their voting rights within the company.
Management roles and responsibilities
Define the roles and responsibilities of each member and, if applicable, any non-member managers. This includes decision-making authority, daily operational responsibilities, and any limitations on the authority of certain members.
Decision-making processes
Clearly outline how major business decisions will be made. Will decisions require a unanimous vote, a majority vote, or a different threshold? Having these rules in place prevents impasses and ensures a smooth decision-making process.
Buy-sell provisions
Buy-sell provisions address what happens when a member wants to leave the business, sell their ownership interest, or passes away. These provisions can help maintain the stability of the company during transitions and prevent unwanted third-party involvement.
Dissolution procedures
In the unfortunate event that your LLC needs to be dissolved, your operating agreement should outline the steps and procedures for doing so. This can include how assets will be distributed and any outstanding debts or obligations.
Drafting your operating agreement
Now that you know what to include in your operating agreement, you may wonder how to create one.
DIY vs. hiring legal counsel
You have two main options when it comes to drafting your operating agreement: you can either create it yourself using online templates and resources or seek legal counsel to draft a customized agreement.
DIY operating agreement
Pros:
- Cost-effective.
- Immediate access to templates and resources.
- Allows for some level of customization.
Cons:
- May lack legal expertise.
- Might not address all unique aspects of your business.
- Increased risk of errors or omissions.
Hiring legal counsel
Pros:
- Ensures a legally sound and tailored agreement.
- Addresses specific needs of your business.
- Provides legal guidance on best practices.
Cons:
- Higher initial cost.
- May involve longer turnaround times.
- May be unnecessary for simpler business structures.
Common clauses to consider
Regardless of whether you create your operating agreement yourself or hire an attorney, there are several common clauses you should consider including:
- Managementand decision-making: Clarify how decisions will be made, who has authority, and how managers or officers are appointed.
- Capitalcontributions: Detail the amount and timing of contributions made by each member.
- Profitand loss allocations: Describe how profits and losses will be distributed among members.
- Withdrawaland transfer of ownership: Outline the process for members who want to sell or transfer their ownership interest.
- Disputeresolution: Specify the process for resolving disputes among members.
- Amendmentprocedures: Explain how and when the operating agreement can be amended.
Frequently asked questions (FAQs)
What happens if my business doesn’t have an operating agreement?
If your LLC doesn’t have an operating agreement in place, it may default to the default rules and regulations of your state. This could lead to uncertainty regarding ownership, management, and dispute resolution, potentially putting your personal assets at risk in the event of legal issues.
Can I change my operating agreement after it’s been established?
Yes, you can amend your operating agreement. In fact, it’s a good practice to review and update it periodically as your business evolves. However, any amendments should be agreed upon by all members and documented in writing.
Do all members need to sign the operating agreement?
Yes, it’s essential that all members of the LLC sign the operating agreement to make it legally binding. Without the signatures of all members, the agreement may not hold up in court if a dispute arises.
Is an operating agreement required by law?
While an operating agreement is not always legally required, it’s highly recommended for LLCs. It provides clarity, protection, and a formal structure for your business operations. Some states may not explicitly require it, but it’s still considered best practice.
What’s the difference between an operating agreement and a partnership agreement?
An operating agreement is specific to limited liability companies (LLCs), while a partnership agreement is used for general partnerships. While both documents outline the internal workings of a business, they apply to different business structures. An operating agreement is tailored to LLCs, offering the liability protection they provide.
Key takeaways
- An operating agreement is a critical document for LLCs, outlining ownership, management, and decision-making.
- It protects personal assets from business liabilities and resolves disputes.
- Include ownership percentages, management roles, decision-making processes, buy-sell provisions, and dissolution procedures in your agreement.
- Consider seeking legal counsel to ensure your agreement meets your specific needs.
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