The Importance of an Operating Agreement for an LLC
When forming a Limited Liability Company (LLC), one of the most critical documents you can create is an Operating Agreement. This internal document outlines how the LLC will be managed, the rights and responsibilities of its members, and key procedures for decision-making, profit distribution, and dispute resolution. While not always legally required, an operating agreement is essential for protecting your business and ensuring long-term success.
In this article, we’ll explore what an operating agreement is, why it’s important, and the key provisions it should include.
What Is an Operating Agreement?
An operating agreement is a legally binding document that governs the internal operations of an LLC. It establishes the roles, rights, and obligations of the LLC’s members (owners) and provides a framework for managing the business. The agreement may also address financial matters, including profit sharing, capital contributions, and procedures for handling business disputes.
The operating agreement is designed to prevent misunderstandings and conflicts among members by clearly defining how the business will operate. This is particularly important for multi-member LLCs, but even single-member LLCs can benefit from having a formal document in place.
Is an Operating Agreement Legally Required?
The legal requirements for an operating agreement vary by state. Some states, like California, New York, and Missouri, require LLCs to have an operating agreement, though the agreement does not necessarily need to be filed with the state.
In other states, including Arizona, Iowa, and Nebraska, an operating agreement is not legally required but is strongly recommended. Without one, your LLC will be governed by your state’s default LLC laws, which may not reflect your business’s specific needs or goals.
Why Is an Operating Agreement Important?
Creating an operating agreement offers numerous benefits, both legal and operational. Below are some of the key reasons why every LLC should have one.
1. Protects Limited Liability Status
One of the main reasons entrepreneurs choose to form an LLC is to limit personal liability for business debts and obligations. However, failing to maintain proper business practices, including having a clear operating agreement, can jeopardize this protection.
In the event of a lawsuit or creditor claim, courts may look at whether the LLC is being operated as a legitimate business entity. Without an operating agreement, it may be easier for a plaintiff to argue that the LLC is not separate from its members, a concept known as piercing the corporate veil. This could expose members’ personal assets to liability.
A well-drafted operating agreement helps demonstrate that the LLC is a separate and fully functioning legal entity.
2. Defines Ownership Structure and Member Roles
For multi-member LLCs, ownership and management responsibilities can become unclear without a formal agreement. An operating agreement specifies:
- Ownership percentages for each member.
- The amount of each member’s capital contributions to the business.
- Roles and responsibilities of each member or manager.
By clarifying these details upfront, you can prevent misunderstandings and disputes later on. For example, if one member believes they should have a greater share of profits due to their contributions, a written agreement can resolve the issue by clearly defining profit distribution terms.
3. Outlines Profit Distribution and Financial Procedures
The way profits and losses are distributed among LLC members can vary significantly based on the business model and member agreements. Without an operating agreement, state default laws may require profits to be divided equally among members, regardless of ownership percentages or contributions.
An operating agreement allows you to customize profit distribution according to your business’s needs. You can:
- Allocate profits and losses based on ownership stakes or other criteria.
- Specify how and when distributions will be made.
- Address procedures for handling additional capital contributions or loans from members.
This financial clarity can help prevent disputes and ensure that all members are on the same page regarding their financial rights and obligations.
4. Provides a Framework for Decision-Making
Running an LLC requires making important business decisions, and disagreements among members can slow down or derail operations if there is no established process. An operating agreement sets out the rules for decision-making, including:
- Voting rights: Does each member get one vote, or are votes weighted based on ownership percentages?
- Approval thresholds: What types of decisions require a majority, supermajority, or unanimous vote?
- Management structure: Will the LLC be member-managed or manager-managed?
By having these procedures in place, you can avoid gridlock and ensure that critical business decisions are made efficiently.
5. Helps Resolve Disputes
Conflicts among business partners are common, especially in growing companies. An operating agreement can help prevent disputes by establishing clear procedures for conflict resolution. Common provisions may include:
- Mediation or arbitration: Requiring members to use alternative dispute resolution methods instead of going to court.
- Buyout provisions: Defining how a member can be bought out if they want to leave the business or if other members want to force their exit.
- Deadlock resolution: Outlining steps to resolve situations where members are unable to agree on major decisions.
By addressing potential conflicts in advance, your operating agreement can save time, money, and stress down the line.
6. Protects the Business from Member Departures
Changes in ownership can significantly impact an LLC’s operations. If a member leaves the company—whether voluntarily or due to death, disability, or other circumstances—the business could face uncertainty without a clear plan.
An operating agreement can include buy-sell provisions, which dictate how ownership interests will be handled in these situations. For example:
- Remaining members may have the right to buy out the departing member’s share.
- The agreement may establish a process for valuing the business and determining the buyout price.
- Restrictions can be placed on the transfer of ownership interests to outside parties.
These provisions help ensure that the LLC can continue operating smoothly and that ownership changes do not disrupt the business.
7. Prevents the Application of Default State Laws
Without an operating agreement, your LLC will be subject to your state’s default laws regarding matters such as profit distribution, member roles, and dispute resolution. These default rules may not align with your business’s unique needs or the agreements between members.
By drafting a tailored operating agreement, you can take control of how your LLC is governed and avoid the uncertainty of relying on state-mandated rules.
Key Elements of an Operating Agreement
While each business is unique, certain provisions are commonly included in an operating agreement. These include:
- Business Information:
- Name of the LLC, registered agent, and principal office address.
- Ownership Structure:
- Names of members and their ownership percentages.
- Capital Contributions:
- Details of each member’s initial and ongoing financial contributions to the business.
- Profit and Loss Allocation:
- How profits and losses will be distributed among members.
- Management Structure:
- Whether the LLC is member-managed or manager-managed, and the roles and responsibilities of each.
- Voting and Decision-Making:
- Rules for voting on major decisions and the required thresholds for approval.
- Membership Changes:
- Procedures for admitting new members, handling member departures, and transferring ownership interests.
- Dissolution and Liquidation:
- Steps to wind down the business and distribute remaining assets if the LLC is dissolved.
- Dispute Resolution:
- Processes for resolving conflicts, including mediation or arbitration clauses.
Do You Need an Attorney to Draft an Operating Agreement?
While it’s possible to draft an operating agreement without legal assistance, working with an experienced attorney is recommended. An attorney can ensure that the agreement complies with state laws, reflects the specific needs of your business, and addresses potential legal risks.
At Checketts Law, PLC, we have extensive experience helping LLCs create comprehensive and enforceable operating agreements. We’ll work with you to tailor the document to your business goals and protect your interests.
Conclusion: Secure Your LLC’s Future with an Operating Agreement
An operating agreement is a vital document that establishes the foundation for your LLC’s operations, governance, and long-term success. By creating a clear, legally enforceable agreement, you can protect your limited liability status, prevent disputes, and ensure that your business runs smoothly.
Whether you’re forming a new LLC or updating an existing agreement, contact Checketts Law, PLC today at 888.686.6211. Our professionals can guide you through the process and provide the peace of mind that comes with a well-crafted operating agreement. Schedule a consultation to get started!
**DISCLAIMER: Accessing or reading this post does not create an attorney-client relationship nor is the information offered as legal advice. Checketts Law, PLC only provides legal advice to clients, and a party becomes a client only after signing an engagement letter which has been signed by an attorney legally authorized to act on the firm’s behalf.