In any limited liability company (LLC), there needs to be an outline of how the business operates. Termed an operating agreement, this document isn't required by most states in which you file your business registration but is helpful as a guide to help individuals understand how the business itself functions. The New York Division of Corporations mentions that an operating agreement helps define the rights, duties, powers, and obligations of any member of an LLC. In simpler terms, the operating agreement serves as a guideline for the internal operations of a particular enterprise.
Why Does a Business Need an Operating Agreement?
If the operating agreement isn't needed for registering the company, does the business even need one? Operating agreements are essential to ensuring that some aspects of a business are documented and laid out in an easy-to-understand fashion:
- Protecting your agreement: Any LLC that doesn't have an official operating agreement will begin using the state default operating agreements. Each state has an outline of the rules that businesses default to when they don't file their own operating agreements. Unfortunately, the state default rules are incredibly generic. It's not advised that any business utilize the default operating agreement if they have a choice.
- Clarifying Verbal Agreements: Some agreements that occur with regards to the company happen as verbal contracts. With nothing written down, misunderstandings can lead to conflict within the membership of the LLC. The operating agreement offers a means of formalizing operations and other verbal contracts within the business.
- Protecting personal protections: Limited liability companies use the operating agreement as a means of retaining their personal protections. Without the details specified within the operating agreement, a business's operation may resemble a partnership or sole proprietorship without the protections that an LLC offers.
- Ownership Percentages: The operating agreement will state what each person's interest in the company is among the members.
- Buyout and Buy-Sell Provisions: In the event that a member leaves or dies, the operating agreement will outline how that person's percentage of the LLC will be distributed, along with the procedure for distribution.
What Information Should a Business Include in an Operating Agreement?
When a business develops an operating agreement, they need to include certain bits of information within the document. Among these are:
- Identifying Information: The name and address of the LLC are included in this section, along with the names and addresses of the members that make up the LLC's ownership.
- Ownership Percentage: Each member's ownership expressed as a percentage of the business's entirety.
- Duties and Compensation for Members: What are the responsibilities of the members, and what should they expect to be paid as compensation.
- Management: The business's management structure will be defined there, stating it as either member-managed or manager-managed.
- Profit Distribution: Each member will be required to share in the profits and losses of the business, but the exact sharing percentages can be delineated here. Members need not rely on their stake in the company to determine profit-sharing. The agreement will also outline if profit-sharing payments are likely to be made regularly if it rests on the owners to withdraw funds as they see fit.
- Voting Rights: While many of a business's decisions may be made informally, the controversial choices will have to be put to the vote. There are two ways that power may be split among members of an LLC. Per-capita voting sees each member get a vote. Percentage voting sees each member allowed a say based on their input into the LLC. The latter voting method is the default for most LLCs.
- Term of Operation: In some cases, a business may only need to operate within a short time window. If the LLC was derived to fulfill a particular purpose, it might have a limited period to achieve its goal, after which it will shut down. If that is the case, the operating agreement will make a note of this limit.
- Admitting and Withdrawal of Members: As the business expands or more investors join the company, there needs to be a defined methodology for admitting them as members. The operating agreement helps to explain those things.
- Capital Contributions: The operating agreement may also record how much each member contributed to the business's initial startup costs and whether that recorded value is cash, property, or services. There's also a stipulation as to whether any further contributions are required from a particular member. Additionally, it may cover if members are allowed to add capital to the pool (potentially to change their ownership stake of the business).
- Transferring Interest: If a member wishes to sell their interest in a company for whatever reason, the operating agreement defines the rules for their sale. Most agreements default to allowing the remaining members to have the "right of first refusal" on these sales to keep the shares of the business within their hands.
- Death of a Member: Upon a member's death, the operating agreement also defines how their shares are redistributed or sold. Provisions may be made to transfer the shares to a next-of-kin as well if the members prefer that model.
- Dissolution. When the business is ready to close, the procedure for dissolving the business and distribution of assets may also be defined within the operating agreement.
How To Create an LLC Operating Agreement
Drafting an LLC operating agreement must take into account a few key responsibilities. The operating agreement will be the "go-to" document to advise members how the business should operate in any given situation. For those seeking to draft an operating agreement themselves, several steps can help create an outline:
- Review the LLC's members, their responsibilities, and ownership percentages and take note of them. How is the company's ownership distributed? Are profits paid in the same ratio or a different one?
- Develop provisions for the management structure of the business. Is the company going to be run by its members or by a manager hired for that purpose?
- Examine the company's tax regime and determine what would benefit the business more. Is it more viable to have the business taxed as a C-Corp or S-Corp than an LLC?
- Include provisions that deal with member actions. What happens in the case of a member's death, divorce, retirement, or disability?
These steps assure that your business has a well-outlined plan in any eventuality. Consulting a lawyer can help you sort through these questions and craft a solid operating agreement.