Do I Need an Operating Agreement for My LLC?
Published on June 23, 2022 in Business Law
In short, most likely. While operating agreements are not required by law for limited liability companies (LLCs), LLCs are generally wise to implement them. An operating agreement governs the relationship between the LLC and its members and managers, and dictates the internal operations of the business. Without an operating agreement, the LLC is governed by the limited liability company statute of the state in which the LLC is organized. While this may be acceptable for some single-member and very early-stage operations, it is generally not advisable to leave the operation of your LLC up to the broadly drafted state rules.
So, why is it smart for LLCs to have operating agreements?
If you are forming or have recently formed an LLC and are contemplating the need for an operating agreement, this article is for you. While the members of a new LLC might be excited about their new business venture and unwilling to entertain the notion that things could be misunderstood or disputed, it is important–for both legal and business purposes–that the members of an LLC discuss and sign an operating agreement.
Establish the Basics
The operating agreement memorializes basic information such as the company name, term (generally indefinite), location, and the identity of the LLC’s registered agent for service of process. While some of this information might also be included in the LLC’s articles of organization, other basic information can be added, such as the purpose of the LLC, or the type of business it is permitted to conduct. The purpose can be as general or as narrow as the members decide.
Clarify Ownership of the Members
Establishing everyone’s understanding of who owns what is perhaps the most important reason for an operating agreement. While the members of an LLC may think handshake deals are sufficient, oral agreements carry with them substantial risks of misunderstanding and miscommunication. Reducing agreements of the members to writing clarifies misunderstandings early on, and helps avoid disputes concerning ownership. If all members are not on the same page, this can have significant repercussions to everyone’s respective understanding of their voting rights and entitlement to distributions. An operating agreement memorializes everyone’s ownership percentage such that there can be no doubt as to each member’s interest in the LLC.
Establish Required Contributions
Like ownership, each member’s purchase price for their membership interest is a key term and should be documented to avoid any miscommunications. Whether a member’s contribution is in the form of cash, property, or “sweat,” it should be set forth in the operating agreement. This helps avoid any issues with adequacy of consideration of the agreement itself, and also solidifies the adequacy of each member’s contribution among the other members.
Furthermore, the operating agreement should address the situation in which the LLC needs more capital. Can the LLC make a capital call from its members or not? These are issues which a well-drafted operating agreement can cover from the beginning of the LLC’s life.
Clarify Powers and Duties of Members and Managers
An LLC can be either member-managed or manager-managed. Whichever structure you elect, it is important to describe what is expected from those charged with management of the LLC. An operating agreement allows you to spell out all these expectations at the beginning of the relationship. If any particular member is expected to have special responsibilities, those can be specified as well. Additionally, the LLC can create mechanisms to elect and retain officers, such as president, secretary, etc.
The operating agreement is a flexible tool for imposing management structure. Any business structure takes relationships into account in terms of management, and your LLC should be no different.
Enumerate Decisions Requiring Member Approval
In a manager-managed LLC, a manager will be charged with “day-to-day” operation of the LLC. However, there are major decisions which should generally fall to the members. For example, such things as selling the assets of the LLC, declaring bankruptcy, or merging with another company would generally be things requiring member approval. Your operating agreement can list out the decisions which you and your fellow members consider “major” enough to require member approval.
Explain Voting Rights
Members generally have voting rights with respect to LLCs. Your operating agreement can clarify whether these voting rights are proportional to their interests in the company, or whether each member simply gets one vote. Other requirements relating to meetings, consents, notice and quorum can similarly be addressed in the operating agreement, so there are no surprises when it comes to the manner in which the LLC takes action.
Furthermore, you might require more customization than the state default rules offer. For example, your operating agreement can create the ability to make certain “big” decisions with a supermajority of members as opposed to requiring unanimous consent.
Protect Members from Individual Liability
One of the main purposes of forming an LLC is to insulate individual members from liability. An LLC can be formed without an operating agreement, so an operating agreement is not necessarily required to protect individual members. However, should some third party seek to “pierce the corporate veil” and hold individual members responsible for some act of the company, an operating agreement–and adherence to that agreement–can go a long way towards demonstrating to a court that all corporate formalities were followed.
Address Profit and Loss Sharing and Distributions
An operating agreement governs the amount and frequency of the members’ distributions of profits (or losses). This helps avoid any surprises when it comes to funds being distributed from the company coffers. Whether you place distributions in a manager’s discretion, or require periodic distributions, the operating agreement helps an LLC tailor its approach to the needs of the business and the members.
If you have a closely held LLC, do you want your fellow members to be able to sell their interests to anyone off the street? Doubtful. Your operating agreement is an opportunity to restrict the transfer of membership interests so that your members actually fit the business and vice versa. The members can grant the LLC and/or themselves rights of first refusal over the interest to be conveyed, and can make distinctions between substitute members (with voting rights) and mere holders of an interest.
Also, to the extent the operating agreement provides restrictions on transfers and rights of first refusal, it can also provide specific timeframes within which transactions must be accepted, closed, etc. This helps avoid any confusion about who has what rights when it comes to the transfer of interests in the LLC.
Tax and Accounting
You want to make sure that your LLC has guidelines for ensuring that books and records are properly kept and that the LLC stays in the good graces of relevant tax authorities. The operating agreement can set rules for making sure the LLC does so, tasking particular members with responsibility for tax matters, and setting certain baseline standards for maintaining books and records of the company.
While no one ever thinks their LLC will fail or that relationships with fellow members will become strained, these things do happen. Whether its bankruptcy, deadlock, or members leaving the company, the operating agreement offers the members customizable ways in which to either continue operation or dissolve–hopefully without the need for judicial intervention.
To avoid disputes and litigation, it is always advisable to have an operating agreement which offers clarity concerning the dissolution and winding up of an LLC.
DISCLAIMER: This is for general informational purposes only and not furnished for purposes of offering legal advice. The best source of information for your specific matter is consulting an attorney.