Operating Agreement

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What Is an Operating Agreement?

An operating agreement is a legally binding document that limited liability companies (LLCs) use to outline how the company is managed, who has ownership, and how it is structured. If a company has multiple members, the operating agreement becomes a binding contract between the different members. In addition to clarifying ownership and structure, the operating agreement can also name the registered agent, give details like when meetings are held, select managers, and explain how the business can add or drop members. Simply put, the operating agreement outlines a business's functional and financial decisions. Once the members of the LLC sign it, they are officially bound to its terms.

Most operating agreements contain six key sections, including:

  • Organization
  • Management and voting
  • Capital contributions of members
  • Membership changes
  • Distributions
  • Dissolution

Why You Need an Operating Agreement

There are several reasons why you need an operating agreement, including:

  • Clarifies verbal agreements: The operating agreement puts all agreements between the managing members in writing, so there are no misunderstandings. Members can then refer back to the operating agreement in the event of conflicts in the future.
  • Protects members from personal liability: The operating agreement is a formality that protects the managing members from being personally liable.
  • Ensures you aren't subject to default state rules: When a business doesn't have an operating agreement in place, the default rules set by the state will apply. For example, states have default rules that require the company to divide profits and losses equally. To avoid having to rely on your state's basic operating rules, you should have an operating agreement in place.

How Operating Agreements Work

Because an operating agreement spells out an LLC's terms according to the members, it's a good idea to create one during the startup phase of your business, as it brings in clarity for future management and operations. While operating agreements aren't mandatory in all states, it's a good idea to have one, since it protects the company, prevents future misunderstandings between owners, and establishes rules for how you will run the business. Once the operating agreement is complete and signed by all members, it should be kept in a safe location to refer back to as necessary.

Operating Agreement vs. Articles of Organization

Both of these are important documents when you're starting an LLC. However, the Articles of Organization, also referred to as the Certificates of Formation, are filed with the state to register it as a legal business entity. The operating agreement is an internal document. While it's legally binding in the same way that the Articles of Organization are, it doesn't need to be filed with the state.

What to Include in Your Operating Agreement

There are a wide number of topics that you should address in your operating agreement. Some of these will depend on the needs of your business and your particular situation. However, most operating agreements should include:

Members' Percentage of Ownership

The owners of a company usually make contributions of services, cash, or property to get a business up and running. Typically, they receive a percentage of ownership that's proportionate to the capital they contributed when starting the business. That said, members are welcome to divide ownership any way they like. However, ownership percentages should be clearly defined in the operating agreement.

Distributive Shares

Distributive shares refer to the sharing of profits and losses. Oftentimes operating agreements will allocate distributive shares in the same way as the percentage of ownership. For example, if you own 25% of a business, you would then receive 25% of the profits and losses. However, you don't have to follow this rule. You could give an investor 25% ownership of a business but only assign them 10% distributive shares. That said, if you do choose to assign distributive shares that aren't in proportion to the ownership percentages, you will still have to follow the rules for special allocations.

Allocation of Profits and Losses

Your operating agreement should also clearly define how much of the allocated profits should be distributed to members every year. It should also answer whether the members can expect the business to pay them enough to cover the cost of the income taxes they will owe on profits. In addition, it should articulate whether the owners are allowed to draw money from the business's profits at will or whether distributions will be made regularly.

Voting Rights

The operating agreement should also explain how you will handle voting on major decisions. For example, will each member have one vote, or will each member have voting power that corresponds to their ownership percentage?

Transitions in Ownership

It's important to have a plan in place that is clearly articulated in the operating agreement for how you will handle situations if one of the members decides to retire, passes away, or wants to sell their interest in the company. Your operating agreement should include rules for what will happen if a member decides to leave for any reason.

Basic Provisions in an Operating Agreement

Most operating agreements include the following basic provisions:

  • Name of the LLC: The operating agreement should always include the name and address of the registered office and business office.
  • Statement of Intent: This states that the agreement is in accordance with state laws and comes into existence when the official documents are filed.
  • Business purpose: This statement defines the business's purpose, including the nature of the business, and often includes a statement like "and for any other lawful business purpose" to cover the business in the event of future changes.
  • Term: This states that the business will continue until terminated or dissolved according to state law.
  • Tax treatment: This articulates how the business will be taxes, whether by a partnership, sole proprietorship, or corporation.
  • New members: This outlines how a potential new member could acquire an interest in the business.

Other Types of Provisions

There are some other types of provisions that companies commonly include in operating agreements, including:

  • Identification of managers and members: This lists the names, titles, and addresses of the initial members and any managers if there are any.
  • Capital contributions: This lists the initial capital that each member contributes and what the value is.
  • Additional capital contributions: This states whether members are allowed to make additional contributions and whether it's required.
  • Member meetings: This outlines when meetings will be held and any rules that apply in meetings.
  • Dissolution: This provides procedures and conditions for dissolving the business.

While the provisions and topics presented above are the major provisions that companies tend to include in their operating agreements, the list is by no means exhaustive. Because it's a document made specifically for your company to address circumstances you anticipate encountering, you can essentially include anything you want. For example, you could include restrictions on who is allowed to sign a check or how disputes will be resolved.

It's also important to keep in mind that the operating agreement, while legally binding, can be changed at any time through the process of your choosing. That means that as the company grows and changes, you can make changes as necessary to meet the needs of the business and its members.

There are a lot of practical, legal, and even tax considerations that you may want to consider as you're tailoring your operating agreement for your business's needs.

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