Whenever you drive to a new location, a road map is a necessity. Without it, you risk making a wrong turn, driving out of your way, or getting lost.
The same goes for new businesses; you need instructions that will guide your new business venture to its goal. For an LLC, that’s what a good operating agreement does. It sets your business up for success.
Unlike some fill-in-the-blank forms, the operating agreement is a document you create. But if that sounds daunting, don’t worry. This guide will walk you through the process of creating your operating agreement.
What It Is:
The operating agreement is just that: an agreement. It’s a document that’s written by the LLC’s members—for the members. The agreement details how the LLC will be run by setting out the roles and privileges of each member.
The operating agreement, once written, becomes a part of the LLC’s business records. The agreement is to an LLC what the bylaws are to a corporation. That said, an agreement is usually much shorter and easier to create than bylaws.
- A document written by the members, for the members
- Details how the LLC will be run by setting out the roles and privileges of each member
- Part of the LLC’s records; is to an LLC what the bylaws are to a corporation (but usually much shorter)
Why You Need One:
Every LLC should draft an operating agreement. In some states, an operating agreement is a legal requirement. Even if your state doesn’t require it, you’ll want to write an agreement to keep your business running smoothly. The agreement can help settle disputes between your members; when a disagreement occurs, your members can consult the agreement to clarify the rights and privileges of each member.
A vital component of the operating agreement is a description of how profits will be passed to members: when, what percentage, and more. Because of this, many banks require a copy of your agreement before they’ll grant you a business bank account. A business account is essential.
What about single-member LLCs? Perhaps you’re thinking that, as the only member, you don’t need to agree with anyone but yourself. Easy, right? That may be true. But it’s still recommended that you draft an operating agreement that gives provisions for how new members can join the LLC.
You never quite know exactly how your business will grow. Setting up an operating agreement anyway will help make a transition seamless if and when new members join your business.
What It Contains:
There is no one-size-fits-all operating agreement. However, every agreement should contain certain basic sections. We’ll cover some of those essentials here.
Business name and purpose: This may seem like a given, but your first section should list basic information about your LLC. Creating a mission statement is a good way to make sure your members are all on the same page. It also gives you a written record of your goals.
You should also provide contact information for your business, such as your principal address (if you have a brick and mortar business).
Division of profits: As we’ve alluded to earlier, the operating agreement sets up how your profits are split. This can be an equal share per member, a percentage that’s proportionate to the stake each member has, or another method that works for you. What’s important is that you define how the profits go.
You should also include how the flow of profits would change if a member leaves or a new member joins. A large majority of business disagreements occur over money, so defining this ahead of time should alleviate tension between your members.
Capital investments: Each member of an LLC brings something unique to the business: management savvy, skill in the trade, and more. It’s not uncommon for some members to bring capital investments into the business. Your initial agreement should put in writing a description of what each member brings to the LLC.
Taxation: A key feature of an LLC is it’s flexible taxation. You can elect exactly how your LLC will be taxed. Many smaller LLCs prefer to be taxed as a pass-through entity or an S Corporation, but larger LLCs might prefer taxation as a corporation.
For this step, legal counsel can be helpful. Each business is different, and a tax lawyer can help you choose which taxation approach is best for you. Once you’ve made that choice, include it in your operating agreement.
Management: There are two forms of management commonly used by LLCs: member-managed or manager-managed. For LLCs, the term “manager” entails “owner,” so the member-managed LLC is managed by the owner or owners. This approach is best if you want direct control over the business affairs each day. Most entrepreneurs favor the member-managed LLC.
The manager-managed LLC resembles the officers of a corporation. Instead of managing the LLC themselves, the members of the LLC appoint managers to oversee the day-to-day affairs.
Membership provisions: As your business grows and changes, you may want to add or remove members. Your operating agreement should describe how that process unfolds. For example, your members may vote to add or remove a member, with a majority or unanimous vote necessary to pass.
Dissolution: In the beginning of your business venture, you’re hoping for a successful launch. Thinking about how you’ll close your business seems depressing. However, it’s important to make provisions on how to end your LLC just in case. For instance, your agreement could require a unanimous vote before dissolution is allowed or a simple majority. You’ll also want to set up how the LLC’s remaining assets would be divided among the members once you’ve dissolved.
Acquiring additional capital: Investing in your business’s future is a vital component of your business strategy. Along the way you might purchase additional property, vehicles, equipment, or other costly investments. You might also apply for loans or issue bonds to investors to raise funds. Since many of these decisions can incur debt and interest payments, it’s especially important that all members are on board with the purchase. Your operating agreement can set up the procedure for making these important decisions.
Amendments to the agreement: When you first draft your agreement, it fits your business perfectly. But over time, your business will change. New membership or a big increase in the size of your LLC could make your agreement out-of-date.
That’s why one of the closing sections of the agreement should include the procedure to change the agreement itself. The agreement should be semi-permanent (you don’t want to make spur-of-the-moment changes), but flexible enough that you can adapt it as the business evolves.
Other rules: Each business has unique needs, so the above sections might be insufficient. Your LLC’s members can add sections as needed. For example, if your business imports materials from foreign sources, you may want to set up procedures for those acquisitions. You know your business best, so if there’s a unique feature to your business, you should establish procedures for it in the operating agreement.
What Happens If I Don’t Use an Agreement?
In states where an agreement is required, failing to use one costs you your good standing. You could face a lawsuit and hefty monetary penalties from the state. Then, if you continue operating without an agreement, the state could dissolve your LLC by force.
However, not all states require you to write an agreement. If you elect not to write one, there is no penalty. In this circumstance, the state’s rules for LLCs (usually set out in the Limited Liability Company Act) govern your LLC.
This approach makes your start-up process simple, but there is a drawback: the state’s laws are an umbrella policy. These operating laws will not be customized to your business.
How to set up an agreement:
Since the agreement is such an important part of your business, the process of drafting it is no simple matter. Fortunately, you have several options for this step. For one thing, you can use a template. Online business services like Nolo, IncFile, and Rocket Lawyer offer templates that you can download and fill in. Some templates are even free, and you can add or delete sections as needed. The template takes out some of the guesswork.
Another option is to hire a business lawyer. Your members and the lawyer can sit down and talk through your business plan. Armed with this information, the attorney can write the perfect agreement for your LLC. This option will surely cost more, but you can be confident that your agreement is appropriate and comprehensive.
You can always draft the agreement yourself, too. If you choose this option, it’s highly recommended to read a few sample agreements or at least browse the templates. Then you’ll have an idea of what your agreement should look like, including what language to use.
Once your agreement is drafted, you are not required to file it with your Secretary of State. You should add the agreement to your business records.
Drafting an agreement can be tricky, but it’s well worth your effort. The agreement is your road map to success and smooth operation. We hope this guide helped you set up this important document.