How to Draft an Operating Agreement for Your Small Business

You wouldn’t lavish time and money on a building with a bad foundation, would you? That’s what many new business owners do when they form a limited liability company (LLC) without giving real time and consideration to their business operating agreements.

Why is an operating agreement so important to your new LLC? First, it helps to guarantee that the legal protections you’re looking for actually work for you when the need arises.

Second, it walks you through much of the thinking you need to do before you register an LLC with the state. Even single-member LLCs need an operating agreement structured to fit their needs.

Learn what goes into an LLC operating agreement and how to create one that will carry your business through good times and bad.


Overview: What is an operating agreement?

An operating agreement is a legal contract between members of an LLC that spells out how the business will be governed, financed, and managed.

In most states, you do not have to submit an operating agreement when creating an LLC. You can simply file articles of organization with the secretary of state to register your legal business entity.

At this time, only California, Delaware, Maine, Missouri, and New York require you to submit an operating agreement along with your formation paperwork.

If you don’t draft a written operating agreement, the default laws of your state of formation will apply to your company. This means that even if all of your members want something different, if you don’t have written documentation, state laws may override them.

Why do you need an operating agreement?

In addition to being required in a few states, operating agreements protect your LLC business from everyday hazards.

  • Legal protection: If you simply file articles of organization with the secretary of state and go about your business, you may not get the protections you expect from forming an LLC. Courts can “pierce the veil” of limited liability if they find that your LLC was not treated as a separate entity from you personally. This usually results from mingled finances or inadequate documentation. An operating agreement helps to ensure that separation.
  • Dispute resolution: Disagreements among business partners are inevitable. An operating agreement establishes clear roles, responsibilities, and procedures to keep occasional differences from growing into irreconcilable disputes.
  • Control over the business: If you don’t have a written operating agreement, the default LLC laws of your state may override any oral agreements among your LLC’s members. For example, some state laws require unanimous consent to make decisions such as selling assets or taking loans. If you have a handshake agreement that you’re the final decision-maker, but your state laws say otherwise, you can find yourself deadlocked.
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How to draft an operating agreement for your small business

Your operating agreement is a critical document that should be tailored to fit your business needs and the LLC laws of your state of formation. Generally, operating agreements cover these areas.

1. Investment and ownership

The operating agreement spells out each member’s capital investment or contribution to the LLC. This is expressed as a percentage of ownership in the company. This is important because it governs how profits and losses are allocated.

The operating agreement should clearly define each member’s financial interest in the company and the rights and responsibilities that come with it.

2. Roles and responsibilities

LLCs can be managed several different ways depending on the laws of your state. A member-managed LLC means that all members manage the business’s day-to-day operations together. This is the default setup of an LLC.

In a manager-managed LLC, one or more members are merely investors, or silent members, who don’t actively manage the business. The business may be managed by a professional manager or by one or more of the remaining members.

Control over the business is a frequent area of dispute. It usually starts with a casual arrangement in which one member is the main driver of the business.

As time goes on, another member takes on a more active role, or maybe an investor assumes that some decision-making power should come with that investment, and suddenly the members are at odds. That’s why it’s so important to set clear expectations up front.

3. Governance

Corporate governance concerns how a business entity runs itself, rather than how its people manage the business. Governance helps to separate your business from your personal affairs. Your operating agreement should establish key governance guidelines including:

  • Will your LLC have officers or a board of directors? Will they be compensated?
  • How will officers be selected? How long will they serve?
  • How often will the LLC hold meetings?
  • What actions require a vote, and how many votes are needed to validate a decision?
  • What voting rights does each member have?
  • How will you resolve disputes? Does one member have final say, or do you require a majority? Is arbitration required?
  • Who will handle documentation and compliance issues, such as annual reports and audits?

4. Profit distribution

LLCs are pass-through entities, with income and losses passing through to their owners’ personal income.

In many states, profits and losses are automatically distributed to an LLC’s members based on their shares of ownership, but your operating agreement may lay out different terms.

Your operating agreement should cover these important financial decisions:

  • How and when will profits and losses be distributed to members?
  • How will each member’s capital accounts be managed?
  • Who will handle the LLC’s finances and tax returns?
  • Who has the right to review the company’s books?

5. Buyout provisions

Your operating agreement should include provisions for buying out members who want to leave or who suffer a major change such as divorce or bankruptcy. It should also include measures for new members to buy in.

This section is especially important because in many states, your LLC may be automatically dissolved if a member leaves or dies.

Your operating agreement should address these concerns:

  • When can members sell or transfer their interests in the company, and how will those membership interests be valued?
  • Do other members have first right of refusal if a member wants to leave?
  • What happens if a member dies?
  • Who can buy in, and on what terms?
IRS Publication 3402, Taxation of LLCs.

IRS Publication 3402 walks you through the many tax options for LLCs. Source: irs.gov.

6. Noncompete clause

An operating agreement should provide a noncompetition or noncompete clause, if desired, to prevent members from using knowledge or assets from the LLC to engage in competing ventures.

7. Duration and dissolution

When registering your business, you may be asked on your LLC forms to specify a duration for your LLC. Most LLCs elect perpetual duration if it is available. Even with perpetual duration, you need to spell out what happens to your LLC following the death or retirement of its last member.

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Without processes for winding down the company’s affairs, the LLC’s assets may be in legal limbo if a sole member dies.

This is another example of why it’s important for even a single-member LLC to have a written operating agreement as part of its founding corporate records.


Frequently asked questions for operating agreements

Get the answers to your questions about this legal documentation.

What is the difference between operating agreement and articles of incorporation?

Articles of incorporation are not used in LLCs. LLCs and corporations have parallel but different formation documents:

Do I have to create an operating agreement to form an LLC?

Only if you are forming your entity in California, New York, Missouri, Maine, or Delaware. In all other states, it is highly advisable, but not legally required.

What happens if I don’t create an operating agreement?

If you don’t file an operating agreement, your LLC is ruled by the LLC laws of your state by default. Since these may or may not fit your needs, skipping your operating agreement is risky.

Should I create an operating agreement for a single-member LLC?

Yes, even a single-member LLC should create an operating agreement to: establish the parameters of your business as a separate financial and legal entity; provide for bringing in future owners; and facilitate dissolution upon your death.

Can I change my operating agreement once my LLC is formed?

Yes. The operating agreement is a contract between the parties who sign it. You can change it anytime with the parties’ consent, according to the terms of the agreement. If you live in a jurisdiction where the operating agreement is filed with the state, you will likely need to submit the new agreement whenever changes occur.


Build on solid ground

Sample operating agreements can provide a good starting point, but your LLC paperwork should be drafted or reviewed by an attorney. This is a small but critical investment in the life of your business.

With a sound legal agreement between members, your LLC has the best chance of starting strong and staying that way through the inevitable seasons of life.

View more information: https://www.fool.com/the-blueprint/operating-agreement/

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