What is an operating agreement?
< View All PostsIf you have decided to start a Limited Liability Company (LLC), an operating agreement is crucial to help you establish the rules and structure of your business. While the main purpose of an LLC operating agreement is to delegate the rights and responsibilities amongst joint owners, even a single-member LLC benefits from an operating agreement. Once signed, an operating agreement acts as a binding contract cementing the terms of your business and providing proof of your ownership interest.
Why do you need an Operating Agreement?
- Currently California, Delaware, Maine, Missouri, Nebraska, and New York require LLCs to have an operating agreement. However, even if your state does not require an agreement, many banks and investors require you to present an operating agreement to show proof of ownership before they provide financing for your business. You should note that an operating agreement is not synonymous with articles of incorporation (another document required by states). Articles of incorporation are filed with the State to actually form the LLC and are generally public documents. Operating agreements, on the other hand, set out the structure of your business and should be kept private. There’s no need to file your operating agreement, but you should keep the agreement with your other important documents.
- Protect your personal assets. The main advantage of an LLC is to keep your personal assets, like your home, car, and personal checking account, safe from liability in the unfortunate event your business is sued. However, to keep this protection, you must prove that you have not commingled your personal and business assets. One way to prove that your business is separate from your personal life is to adhere to business formalities like keeping and maintaining records of business meetings. An operating agreement is just another way to show that you take your business seriously and operate it like any legitimate business (separate and apart from your personal assets).
- Avoid your state’s default rules. If you choose not to set the rules of your business by creating an operating agreement, then the state will decide the rules for you by applying the default rules created by your state’s legislature. There’s no doubt that you know your business better than a random legislator and an operating agreement helps you to maintain control.
What is an Operating Agreement for an LLC?
Although there’s no set form or required content for an operating agreement, most agreements have six sections: Organization, Management and Voting, Capital Contributions, Distributions, Membership Changes, and Dissolution.
Article I: Organization
The first article is like the birth certificate of the LLC. It sets out when the business was created, who owns the business, and the owners’ interest in the business.
Article II: Management and Voting
If there are multiple owners of the business, you may want the owners to share equally in the management of the business or you may want to delegate rights and responsibilities to owners differently. Either way, this section is where you address how you want the owners to participate in business operations. For example, you may want some owners to be in charge of the day-to-day management of the business, while other owners may want to maintain more voting power in order to dictate the long-term goals and strategy of the business. You may also consider dispute resolution in this section and what to do in case of a stalemate.
- Management: Sometimes co-owners perform different duties in a company. For example, one owner may provide financing and be more interested in the profitability of the business than the day-to-day management of the business. In which case, the owners may delegate the management power to other co-owners who may be more invested in the inner workings of the business.
- Voting Power: You may choose to make important business decisions like re-branding, hiring a new general manager, or investing in a new marketing strategy, through a voting process. Generally, a majority vote is required to implement a new business strategy, but the operating agreement may specify the percentage of votes required for an action. Additionally, instead of the traditional, one person, one vote system, the operating agreement may vary the relative voting power of each owner depending on their financial contribution or management contributions.
Article III: Capital Contributions
Article III covers the dollars and cents of the organization and outlines how much capital each member contributed. Based on the amount of capital contribution, the owners may choose to vary the ownership interests and allocate a greater interest to investors. This section also outlines how more capital will be raised and what percentage of profits will be re-invested in the business.
Article IV: Distributions
Article IV allocates the profits and losses of the business. Many businesses may choose to split profits and losses fifty-fifty, but some businesses may vary this structure based on contributions. For example, if one owner funds the business, but the other owner is the brains behind the operation, the co-owners may split the profits equally and have the brains of the operation take 100% of the loss. This section may also vary the allocation of different types of business assets like money, real property, and intangible property.
Article V: Membership Changes
Throughout the duration of the business, owners may choose to sell their ownership interest, seek to bring in another owner, or experience life-altering events like divorce, bankruptcy, or death. This part of the agreement dictates how and when owners may transfer, lose, or disavow their ownership interest.
Article VI: Dissolution
In the event, your business ceases to be profitable or circumstances change, this section covers how your business will dissolve and may allocate dissolution responsibilities between members. For example, some owners may be responsible for paying off the final debts, selling off business assets, and distributing the final assets amongst co-owners.
How to Create an Operating Agreement?
If you are still wondering what is an operating agreement and how do I create one, contact us today! Using Eco-fyle, you simply need to answer a few questions and we’ll create the agreement for you, keeping it safe and accessible.
