Limited liability companies (LLCs), use an operating agreement to provide details on how a partnership will work. Without this document, companies doing business together will likely fail due to unmet goals and failed expectations between the parties.
LLC’s are one of the most common business entities used by small and mid sized businesses. They provide the personal protection of limited liability with less formalities (typically) than corporations. However, even in light of the reduced formalities, all LLC’s should have an operating agreement in place, whether owned by a single member or multiple members.
What’s the difference between an operating agreement and a partnership agreement? Partnership agreements are used with traditional partnership structures, such as a general partnership, where two or more individuals come together to form a business and don’t take the formal steps of registering the business. Operating agreements are used with LLC’s, both single member and multiple member, and really should not be used interchangeably with the term partnership, although that is commonly done.
So, what is an operating agreement? It’s the key foundational document for LLC’s that outlines the company’s functions, decisions, operational concerns, financial decisions and decision making authority. It’s a governing document that serves to protect the members from personal liability. You may have a single member LLC, with only one owner, implementing an operating agreement is an extremely important step to help separate you individually from the LLC and limit your potential personal liability. It’s also your chance to formalize the agreement, or agreements, you may have come to with any other members who also own a part of the LLC; get them in writing now before they become an issue that will cost significantly more and take time away from the operation of the business. It’s also, or at least should be, a conflict resolution document where you spell out what happens when there are disagreements about company decisions, an owner wants out, dies or becomes disabled or doesn’t live up to their end of the bargain in contributing to the company. At its core it’s a business planning tool that can be extremely important to the success of the company, especially when there are lots of voices to be heard.
LLC’s are not usually required to have an operating agreement, and that leads to many simply ignoring this step. Or, worse yet, taking one from an online resource or form generator that doesn’t apply to the specifics of the individual business. This is a surefire way to end up in trouble. It’s unwise to operate an LLC, regardless of how many members there are, without having an operating agreement in place.
How Do Operating Agreements Work?
It’s an internal document that should be kept with the other company records. Most states don’t require that you keep one on file with the secretary of state or other office. It’s a good idea to create one as soon as possible once you get the LLC registered in your state; as early in the start up process as possible. It brings clarity to your operations, decision making and prevents misunderstandings. Store it in a safe place, either physically or electronically, make sure it’s signed by all the members and refer back to it as needed should issues or questions arise about roles, responsibilities and functions within the LLC.
Make sure to differentiate between an operating agreement and the Articles of Organization. Articles of Organization are filed with the state in order to form an LLC, usually with the Secretary of State or a similar office (in Virginia, for example, they are filed with the State Corporation Commission). The state then returns a Certificate of Organization, and registers the LLC as a legal business entity in the state. As opposed to the Articles of Organization and Certificate of Organization, an operating agreement in an internal document, that typically does not need to be filed with the state.
What Are The Benefits of An Operating Agreement?
- It helps to establish the legal and financial structure of the company. When the paperwork for an LLC is filed with the state, it automatically becomes a registered LLC upon approval. However, without an operating agreement in place the LLC operates according to the default rules and regulations of the state regarding LLC’s, usually, referred to as the states Limited Liability Company Act. This means that absent an operating agreement, state law will dictate how your company operates, what happens if a member wants out, what happens if a member dies (and more importantly, who will own that members’ interest if that does happen, how ownership can be sold and transferred, and other very important decisions that businesses should leave up to the default state regulations.
- In multi-member LLC’s the operating agreement is the mechanism that allows the members to set up a framework for decision-making, management and operations of the company. How will decisions be made, and do you need a majority of the owners to agree or must it be unanimous? Are you a manager-managed LLC or a member-managed LLC? How do you appoint managers if you are a manager-managed LLC; or for that matter how would you remove them if they weren’t performing as expected?
- It helps protect the owners from personal liability. This is particularly true in the case of single member LLC’s. While multi-member LLC's need an operating agreement in order to lay out the management of the company and protect the members from personal liability, single member LLC’s need one to make sure they are limiting their personal liability in all the ways possible. An operating agreement helps demonstrate that the LLC is being run in a professional and responsible manner. This will be important should any person or company try to get through the LLC to the members personally by piercing the corporate veil.
- It provides some level of professionalism to your business. It may be that you are trying to get a bank loan, or get an individual to invest in your company. In those situations, a sole proprietorship or partnership is likely to negatively impact the chances of getting what you’re looking for. Being able to show banks, potential investors, clients and vendors that you have taken the steps to lay a solid foundation for your business and run it in a professional manner will pay off and make your business more respectable.
- It helps lay out how the business will continue in the event a member wants out, retires, passes away or becomes incapacitated. You’ll want to know how to handle a situation where one member decides it’s time to sell his or her share, how you’ll value that share and what the options for purchasing that share, by other members or the company itself, are. It’s also important to think about how the business would handle a situation where new or additional members are brought on. What would that look like, how would that be accomplished and what would the steps involved be?
Have questions about getting an operating agreement setup or reviewed for your LLC? Contact Us for a free consultation.