Does Your LLC Have a Proper Operating Agreement?
‘Shotgun’ Weddings and LLC’s
You (hopefully) would not get married to someone without getting to know them first and having a plan for the marriage. The same goes for forming a limited liability company (or LLC).
We see this so often, we thought it would be appropriate to write about. LLC’s are a very popular form of doing business. Friends, partners and colleagues often rush off to form a LLC without fully understanding the implications. Namely, they fail to understand that in order to fully take advantage of a LLC, it needs an appropriate Operating Agreement.
Now you may wonder why an Operating Agreement is so important? Without one, you open yourself up to significant financial risk and emotional headache should your partner go rogue or some unforeseen circumstance occur to the company itself or one of the owners.
What is an Operating Agreement?
An Operating Agreement is a formal legal document that is signed by all the members (i.e. owners) of a LLC. Anyone who’s ever been married can attest to the fact that it is much better to set ground rules beforehand. The same goes for your business. An Operating Agreement contains everything from mundane clauses on how to vote and powers of members (and managers) to how to handle many extenuating circumstances the business may face. Operating Agreements can be quite long and thorough.
An Operating Agreement is NOT filed with the state where the LLC is formed, but is a private document kept among the owners for reference.
An appropriate Operating Agreement addresses many issues the business will face. Here are some examples:
- How to conduct member votes
- How to count votes of the members (i.e. pro rata according to ownership versus headcount, unanimous versus majority or quorum, vote by proxy and more)
- What powers are reserved to the members versus the managers (if any) and what may be done without a vote, versus what requires a vote
- Establish how to admit new members, and who approves new members
- How to handle if a member wants to leave (i.e. no one can leave, right of first refusal back to the business, etc)
- How to handle the death or incapacity of a member (i.e. estate inherits the membership versus LLC buys the outstanding membership from the estate)
- How the LLC should be taxed
- How to distribute assets and handle liabilities in case of a dissolution
- The establishment of a capital account
- And much more…
An Operating Agreement is not something you can just download off the Internet.
You cannot easily find an Operating Agreement template online. An Operating Agreement is (ideally) custom to your business. It is decided by the owner (or owners) tastes as well as the management and operating style of the members. If you borrow one from the Internet, plan to spend quite a bit of time tailoring it to your particular needs.
The Dangers of Operating without an Operating Agreement
If you do not have an Operating Agreement — you expose yourself to all sorts of potential problems down the road. For instance:
- Without an Operating Agreement you must operate your LLC according to the limited liability act in your state. The exception is if you have an Operating Agreement, which allows business owners to override state law as it relates to operating your company (in most circumstances). Unless you know what your state law is relating to LLC’s, you would do well to incorporate an Operating Agreement that fits your particular operating style.
- If you do not operate your company according to state law (or your Operating Agreement if you have one) you make it possible for a plaintiff to pierce-the-corporate veil in a lawsuit, thereby exposing you personally to the harms and liabilities of your company. In other words, don’t automatically assume you’re immune from personal liability just because you have a LLC. Without an Operating Agreement, you significantly increase the risk that the shield of liability can be removed in a lawsuit, depending on the specific circumstances.
- If a partner wants to leave the business and there is no Operating Agreement controlling the exit, it can get messy. See our article Leaving a Partnership – How To Do it Right for more information about departing partners. Uncontested (or unchallenged) departures are the easiest, but they rarely happen. Contested departures are far more frequent and without an Operating Agreement to control the departure you can end up with a very expensive and debilitating lawsuit, not to mention the emotional fallout.
- If, heaven forbid, your business fails for some reason, an Operating Agreement can dictate how to properly wind down a business. Without an Operating Agreement, you and your partners could devolve into an “every man for himself” situation where the owners put their best interests before those of the company. See Good Business Failure, Why Does it Happen for some ideas on how businesses can fail, even when doing well.
- Without an Operating Agreement, you cannot control who your partner chooses to sell his or her membership interest to. In other words, you could wind up with total strangers as business partners should your partner choose to sell his/her membership! If you care about who your partners are, you want to keep your company “tightly held”. An Operating Agreement controlling how members leave or otherwise requiring the company to have “right of first refusal” of the sale of any membership interest is the way to accomplish this objective.
If you own a LLC, do you have an Operating Agreement in place? If you’re not sure, look for it. If you have one, read it — does it meet your needs and handle how you operating your business? If not, get a new one. If you don’t have one, get one. Don’t wait until problems surface, because then it’s too late.
The Couture Operating Agreement
We built an expert system to help folks create a high-quality, highly customizable Operating Agreement. We call it the Couture Operating Agreement. It’s just $29.95, although it’s free to anyone who forms a LLC or Anonymous LLC with us.