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What is an Operating Agreement? Who Needs It, Why Do They Need It and 6 Crucial Points to Include

An operating agreement (OA) is a legal document used by companies to define their organizational structure, roles and duties of owners and other key parties involved in the business, and methods for handling all transactions that occur within the company. It’s an important mechanism for businesses to record their operational procedures in writing, preventing potential disputes down the line should anything go amiss with regards to operations or ownership changes.

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This post, which will concern Limited Liability Corporations (LLCs), looks at what exactly constitutes an operating agreement, when you need one, how it helps protect your business interests, and tips on creating a successful document.

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To learn more about other terms commonly used in venture capital,ย check out our complete VC Glossary.

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Takeaways:

  • An operating agreement defines the relationship between business owners. Articles of incorporation describe the business’s relationship to the state.
  • This article was written for business owners who wish to understand the differences and similarities between articles of incorporation and operating agreements.

What’s in an Operating Agreement?

Operating agreements can vary in content and form, but they will generally contain six key sections: Organization and Management and Voting; Capital Contributions; Distributions; Membership Changes and Dissolution. This document is paramount in helping to protect the interests of all members involved in a venture capital arrangement.

Article I: Organization

The creation of the company is the first section of the operating agreement. This section covers the creation of the company, the names, and structure of the owners, as well as who they are. Multiple members may have different ownership amounts or equal ownership.

Article II: Management & Voting

The purpose of this section is to outline the relationship between the members. Here, you’ll determine how decisions are made within the company, who has control over certain decisions, and how those powers will be divided among the shareholders. This helps prevent any potential disputes that could arise when it comes to decision-making in the future.

  • The members can manage the company or one or more managers appointed by them. The OA details the members’ authority over the company’s affairs.
  • The company may use a voting process to make decisions. There are many ways that votes can be distributed among members, including one vote per member and one vote per unit ownership interest (if ownership is expressed in units), etc. An OA might specify how many votes are required to take certain actions.

Article III: Capital Contributions

This section explains how much money each member has contributed to the LLC’s formation. This can include any amount of money paid in exchange for equity in the company or for a stake in its operations. It also specifies when those contributions are to be paid, and in what form (cash or equity). This provides a clear understanding of who’s investing what, ensuring that all stakeholders are being treated fairly. This section also describes how members will raise additional funds.

Article IV: Distributions

This section explains how the profits and losses of the company are divided among its members. This could include money, property, or any other business assets. It is important to agree on a distribution structure in order to prevent future conflicts or uncertainty as to how profits should be divided.

Article V: Membership changes

This section explains the procedure for adding or removing members from the company, as well as when and how members can transfer ownership of the LLC. The company might want to include information about what happens if one of its members dies, goes bankrupt, or two members divorce.

Article VI: Dissolution

This final section outlines what happens should a member decide to leave the business or if the company needs to be dissolved for any reason. This is also known as the “winding up” of the company’s affairs. It is important to have these contingencies in place so each party knows exactly what will happen in the event of any changes or dissolutions.

Other Topics

Operating agreements can address many other topics besides the six core sections. It all depends on the company’s circumstances. Members may want to set requirements for regular meetings, restrict check signing or describe how the company will handle disputes. Remember that once you create a business, the OA can be modified at any time via your chosen process.

Why do you need an Operating Agreement

An operating agreement is necessary for several reasons.

  • Clarifying verbal arrangements: The LLC operating agreement outlines all agreements between managing members and puts them in writing, so there are no misunderstandings. In future conflicts, members can refer to the operating agreement.
  • Members are protected from personal liability: The operating agreement is a formality that protects the managing members against being personally liable.
  • Protects you from default state rules. The state’s default rules will apply if a business does not have an operating agreement. States have default rules that force companies to share profits and losses equally. An operating agreement is necessary to avoid relying solely on your state’s basic rules.

What else should you include in your Operating Agreement?

The topics included in your operating agreement may be specific to your company’s needs and your specific situation. However, generally speaking, operating agreements should contain the following:

Members’ Percentage Of Ownership

A company’s owners often contribute cash, services, or property to help get the business started. They typically receive a proportionate share of ownership to the capital they invested in the company’s creation. However, each member can split ownership in any way they wish. The operating agreement should clearly define ownership percentages.

Distributive shares

The sharing of profits or losses is called distributive shares. Operating agreements often allocate distributive shares in the same way that the ownership percentage. If you owned 25% of a company, you would receive 25% of its profits and losses. This rule is not mandatory. An investor could be granted 25% of the business but only 10% of the distributive shares. However, even if you give distributive shares to investors that aren’t proportional to ownership percentages, you will still need to follow the rules regarding special allocations.

Allocation of profits and losses

The operating agreement should clearly state how much the allocated profits should go to members each year. It should state whether members can expect the business to pay them enough money to cover the income taxes they will have to pay on their profits. It should also clarify whether owners can withdraw money from the business’s profits at their will or whether they will receive regular distributions.

Voting rights

You should also include how you will vote on major decisions in your operating agreement. The operating agreement should also explain how each member will vote on major decisions.

Transitions in Ownership

It is important to have an operating agreement that clearly outlines how you will deal with situations such as a member retiring, dying, or selling their share of the company. The operating agreement should contain rules that govern what happens if one of the members leaves for any reason.

How Operating Agreements Work

An operating agreement outlines the terms of an LLC according to its members. It’s a good idea for startup companies to have one. This will allow you to manage your company better and simplify business operations. Operating agreements are not required in every state, but it is a good idea. They protect the company and prevent future misunderstandings.

Operating Agreement vs. Articles of Organization

These documents are essential when starting an LLC. To register the LLC as a legal entity, you must file the Articles of Organization, also known as the Certifications of Organization. A written operating agreement is an internal document. It is legally binding but does not need to be filed with the state.

Operating Agreement Basic Provisions

The following are the basic terms of most LLC operating agreements:

  • Name and address of LLC: The LLC operating agreement should always contain the registered and business offices’ names and addresses.
  • Statement Of Intent: This states that the agreement conforms to state laws and becomes effective when official documents are filed.
  • Business purpose: This declaration defines the business’s purpose and includes the company’s nature. It often includes statements like “and for other lawful business purposes” to protect the business from future changes.
  • Term This states that the business will continue to operate until it is dissolved or terminated by state law.
  • Tax treatment This describes how taxes will be collected from the business, regardless of whether it is a corporation, partnership, sole proprietorship, or sole proprietorship.

Other types of provisions

Other types of provisions are also common in an LLC operating agreement.

  • Identifications of managers and members: This list lists the names, titles, and addresses of the initial members and any managers.
  • Capital contributions This list the initial capital each member contributed and the value.
  • Additional capital contributions This indicates whether or not members can make additional contributions.
  • Member meetings This outlines the dates and rules for meetings.
  • Dissolution: This document outlines the procedures and conditions used to dissolve a business.

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Although the topics and provisions listed above represent the main provisions companies want to include in their LLC operating agreements, this list is not exhaustive. It’s a document you created specifically for your company to address the circumstances you expect to encounter. You can include any information you wish. You could, for example, restrict who can sign checks or specify how disputes will be settled.

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It would help if you also remembered that although the operating agreement is legally binding, you can modify it at any time. This means you can adjust the operating agreement to suit your company’s and its members’ needs as it grows and changes. Just as when the operating agreement was first signed by all the members, any modifications to be signed off by every member.

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When tailoring an operating agreement to your business’s specific needs, you should consider many practical, legal, and tax considerations.

Five ways an operating agreement benefits your business

1. It strengthens your “Corporate Veil.”

Courts might not be as concerned about the business’ limited liability company status without an operating agreement. A single-member LLC operating agreement should contain a liability statement. This will help to limit personal liability.

2. It consolidates central agreements between members

Members of an LLC need to agree on a division of rights and duties, ownership, compensation, and other details when they form their business structure. A LLC operating agreement will enforce these initial guidelines in the future. If the documentation is inadequate, members may find it challenging to ignore company foundational agreements later. The only legal document that addresses the ownership percentages of the company may be a written operating agreement.

3. It outlines key business entity procedures

While articles of organization, sometimes called “certificates of the organization,” make an LLC legal, they do not describe how the company operates. An LLC operating agreement explains how an LLC functions, such as voting, meeting, critical communications, conflict resolution, and other details. Young businesses can benefit significantly from having clear internal operating procedures that are easy to follow.

4. It keeps state default laws at bay

If there is no LLC operating agreement, most states have “default laws” that govern how LLCs operate. An LLC can avoid generic regulations by having its agreement. This gives it more control over defining and regulating its business.

5. It gives your business legitimacy

Entities may view a professional operating agreement as a proxy for a trusted business. It’s easy to form an LLC. This is especially true when you consider the cost of starting a corporation. However, an LLC operating agreement signifies that a company has taken additional steps to organize and operate legally. It shows that the LLC is aware of its legal status, deliberate about its organizational structure, and ready for any challenges.

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Lending institutions are an example of an entity with a vested right to confirm a company’s competence and trustworthiness. Banks may request an operating agreement before opening a bank account for a company.

How to Create an LLC Operating Agreement at an Affordable Price

Creating an LLC operating agreement is usually relatively straightforward according to legal standards. However, the verbal agreements can be lengthy and include legalese. It would be best if you did not attempt to write operating agreements from scratch without a legal background. Also, because they are legally binding, mistakes will be very likely. There are many options.

You can do it (almost) by yourself

You don’t have to rely on your legal knowledge. Instead, you can use a template or step-by-step instructions as a guideline for creating an operating agreement. You can find many different versions online through legal help websites and law libraries. You must ensure that the agreements you sign are appropriate for your business.

Interactive Services

Many websites offering business formation resources, such as Legal Zoom and Rocket Lawyer, offer services specifically tailored for LLCs. Interactive templates allow you to ask questions and gather information about your business before creating an operating agreement. These services are often free.

Automated services may be a better option for creating an LLC operating agreement that suits your business needs. However, they can still fail to deliver optimal results for businesses with unique considerations like foreign transactions or members who are not individuals.

Professional Services

Professional legal assistance is more cost-effective for LLCs with unique requirements, more complex than average, or more than two members. Many lawyers and legal services are skilled in LLC operating agreements. They offer to price individual documents rather than hourly rates. Some websites allow users to post “projects” for different lawyers to offer bids.

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Before you agree to anything, make sure you are clear about whether or not you will be consulting a business attorney. You may be able to ask questions and do rounds of revisions. Or if you are paying for a draft written by a natural person based on your submitted information. Online lawyers should be licensed in your state. They must also be familiar with LLC agreement laws.

The operating agreement costs

While legal expertise can be costly, so is the cost of any legal issues that could arise from a poor operating agreement. Professionally created operating agreements are one of the most significant costs of forming an LLC. A lawyer can write a draft for as little as $100, but some companies spend thousands to create a customized agreement. Many lawyers and other legal services offer free consultations and quotes.

Bottom line

It’s more than just opening your doors to potential customers or clients. This involves establishing formal internal protocols and registering with the government. Although these steps seem tedious, they are essential to starting a business.

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