Operating agreements detail a limited liability company’s (LLC’s) business and the managerial/financial duties of its members. This vital document memorializes an LLC’s rules and structures. While it may seem like a mere formality, this document is actually the most important structure that an LLC creates, as it originates the unique roles and framework of a business.
What key items should entrepreneurs ensure are in an operating agreement in order to make for a well-functioning business?
1. Ownership. Normally, the ownership of a company is divided up based on initial investment. If you put in 50 percent of the capital, you own 50 percent of a traditional company. However, there are times when it’s not appropriate to use this division. For example, if the company is based on your partner’s idea and they’re building the company and you only put in a bit of capital to get the project off the ground, your partner is probably entitled to their fare share of the LLC. Nevertheless, anytime ownership of a company is assigned disproportionately to an investment, it needs to be clarified in the operating agreement.
2. Rights and Responsibilities of Members and Managers. An LLC’s members are traditionally its owners but at times those members may elect a manager to run the company if they don’t want to be heavily invested in its day-to-day management. An LLC’s certificate of formation may even have a section to specify whether the company is directed by a member or a manager. Nevertheless, the document should specify the roles and responsibilities of its members, its managers, and any other key personnel who may have significant influence over the direction of the company. There should also be a plan in place to resolve any disputes.
3. Distribution of Profits and Losses. As with any company, earnings or losses are passed through the company directly to its owners. However, there may be times when a company’s leadership wants to adjust distributions—for example, to stay within a certain tax bracket. Any anomalies in the way profits or losses are distributed should be catalogued within the operating agreement.
4. How to Change Owners. Although not all states require operating agreements for LLCs, most states will dissolve an LLC by default if one of the founding members decides to exit the company. This can leave an LLC in a very poor state, especially if the remaining members desire for the business to soldier on. So if your LLC has multiple owners or members, it is really important to accommodate potential exits. How their share will be distributed, what they can expect in terms of compensation and any terms of written notice should all be addressed and discussed.
5. Dissolving the LLC. Everything under the sun falls down someday. When that day comes for your LLC, you should be able to simply return to the terms of dissolution in your operating agreement. Similar to member exits, the document should clarify how the LLC’s assets will be divided after its debts are paid, as well as who is entitled to what parts of the company. No one likes to think about dissolving their business but going about it in an orderly fashion is better than going through the stress of a lawsuit.
An operating agreement might feel like an afterthought, especially when you are first launching your business. But if you are opening a business with a partner or are thinking about bringing in partners or investors down the road, you absolutely need an operating agreement to keep the company running on all cylinders. Operating agreements are well worth the time and money they take to draft, so before you start doing business as an LLC, make sure you have one drafted by an attorney and formally put into place.