Do I Really Need an Operating Agreement?
Congratulations! You have decided to form a limited liability company (LLC) to run your business. After completing your state formation process, your LLC needs to have the right documentation in place.
So what is “right documentation?” Well, for starters, you need an EIN or employment identification number. That is the number you will use to open up bank accounts for your business.
You also need an operating agreement. “Do I really need an operating agreement?,” some clients ask. Yes, you do.
Let’s explore what an operating agreement is and why you need one.
What Is An Operating Agreement?
First, we need to start with defining what exactly is an operating agreement. An operating agreement is a legal document that describes and outlines how an LLC will operate. The operating agreement is an essential document for owning and operating an LLC.
Why is an operating agreement essential? Well, the operating agreement governs how the LLC is run. An operating agreement alleviates uncertainty and offers clarity to its members.
What should your operating agreement cover? A good operating agreement will cover:
In a nutshell, think of an operating agreement as a guide for your LLC. Just as the name suggests, the agreement determines how your LLC operates. The operating agreement can contain as much detail as you want. And, you can always amend your operating agreement as your business changes.
Flexibility
You are unique and so is your business. Your operating agreement should be unique to your business.
A key advantage of an operating agreement is that you have the flexibility in deciding how your LLC will operate. You get to customize what you want included. You set the rules and regulations for the running of your LLC. Without an operating agreement in place, you have to follow the default rules of your state.
With a customized operating agreement, you decide how you want your LLC to be owned and managed. You get to determine how profits and losses are handled between the members. An operating agreement allows you to determine whether you want to restrict membership interest transfers.
When you are running a business, you need to know who can sign for the business? How will the business be taxed?
A customized operating agreement allows you the flexibility to answer these questions. You get to decide how your business will be fun. Isn’t that the reason you went into business in the first place?
Maintain Members’ Liability
You started an LLC because you wanted to minimize your personal liability. After all, you want to make sure if something happens with the business, your personal assets are not at risk.
And, I’m sure you want to maintain that limited liability for your and all the other members, right? Well, guess what, an operating agreement may help you with maintaining that limited liability.
How? An operating agreement is an extra step to maintain the separation of the the business as an entity vs. its owner. The operating agreement is specific to the LLC. It governs the LLC’s operations and clarifies that the LLC is running pursuant to its own manual, and not the members’ instructions. Such procedure clarifies that the LLC is a separate entity from the members. As such, the members, as long as they are operating within the bounds of the operating agreement, are insulated from individual liability.
Identifies How Decisions Are Made
Remember when you were a kid and created a club with other friends? How many times did arguments break out about “the rules” of the club and who was in charge? My experience was a lot. Why? Well, in my case, my friends and I just decided to band together. We had nothing in writing. We just said one day “let’s make a club.” And, bam, we were a club.
Well, the same misunderstanding can happen when you own a business. Your business needs to have rules in place for how it will operate. The LLC members need to understand their duties and responsibilities. Otherwise, chaos can ensue. And, that is never good for business.
Enter the operating agreement. An operating agreement can provide concrete information on how decisions are made. You need to identify who can make decisions and what decisions can be made. You also need to determine how disagreements will be handled. What if the members can’t agree on a decision? Who has the ultimate tie breaking power?
A well drafted operating agreement will clarify these issues. You need to set up the operating agreement when you start your LLC. You do not want to wait until there is an issue. It is much better to address anticipated issues before those issues arise.
By having an operating agreement in place at the inception, everyone involved knows the LLC”s procedures. While problems may still arise, the operating agreement can help solve most, if not all, of those problems.
May Be Required
Banks will usually require an operating agreement before doing business with an LLC. Some banks will not even allow an LLC to open up a bank account without seeing a copy of an operating agreement.
Additionally, investors need to see the LLC’s operating agreement in order to evaluate whether to invest in the LLC. Same with a bank making a loan to the LLC.
Why? These institutions need extra reassurance that the LLC is fully operable. Often, the operating agreement demonstrates proof that the LLC is a viable company. The operating agreement establishes how the LLC operates.
Conclusion
So, if you are thinking about starting an LLC, make sure you spend the money for an operating agreement. Trust me, the initial financial investment will be worth it.
Likewise, if you already have an established LLC but no operating agreement, run, don’t walk, to your nearest business attorney and ask for one.
Contact us if you need more information or for your small business needs.
