Business owners often (rightfully) decide to form a limited liability company (LLC) through which to conduct their business. LLCs offer many advantages for business owners. However, while these individuals will file the necessary incorporating documents with the state to form their LLC, many of them forget to prepare a critical internal document: the LLC operating agreement.
Many states do not require LLCs to prepare or file an operating agreement. (New Hampshire, Massachusetts, and Florida do not require operating agreements, but, for example, California and New York do.) Even if your state does not expressly require an LLC operating agreement, however, business owners should still consider preparing and executing one for several reasons.
What is an LLC Operating Agreement?
An LLC operating agreement is a contract between the members of an LLC. It sets forth specific terms and guidelines for the operation of the business, the distribution of profits and losses, the addition and withdrawal of members, how the business will be taxed, and other internal issues.
6 Reasons for an LLC Operating Agreement
1) Business Owners Can Avoid Disputes
The greatest advantage of an LLC operating agreement is that it allows business owners to set clear expectations and guidelines for their business, and those expectations will help them avoid disputes. Partnership disputes can be nasty, exhausting, and cost a business and its owners a lot of time and money. The benefits that follow, below, all help business owners outline, in as much detail as they want, how they will conduct themselves and their business. The best operating agreements leave no stone unturned and contain few, if any, areas of ambiguity.
Business owners should carefully review all aspects of their business and their interactions in that business and set clear, specific guidelines for how they will govern themselves. They should then memorialize those guidelines in an LLC operating agreement. They should be specific and detail-oriented to a fault because it will save them time and money down the road if a dispute ever arises.
2) Decide How a Business Will Be Operated
The reason an LLC operating agreement can provide clear expectations for business owners is because it allows them to decide how they will govern and operate the business. This includes how they will make decisions, split profits and pay themselves, distribute work, assign or distribute shares, and assume duties and responsibilities.
For example, three owners of a business might decide that certain decisions require a majority – only two of them – to be valid, while other decisions might require unanimity. In addition, those owners could agree that an owner who contributed only 20% of the LLC’s start-up capital could still be entitled to one-third of the LLC’s profits. Or a savvy businessman (or woman) who partnered with a young tech-savvy entrepreneur to develop a new, cutting-edge product can agree that marketing and overall big-picture duties reside with the savvy businessman (or woman), while the technological development of the product is the tech-savvy entrepreneur’s principal responsibility.
These and other considerations can be explored and memorialized in an LLC operating agreement. Most important: they will help business owners avoid disputes down the road.
3) Protect LLC’s Limited Liability Status
An LLC operating agreement will ensure an LLC maintains its limited liability status. Failing to observe corporate formalities will usually result in the loss of the limited liability the owners of an LLC enjoy. While an operating agreement is not required for business owners to sleep peacefully at night knowing they are not personally exposed for their business’s activities, an LLC invites more respect from other businesses, business owners, and courts if it has and maintains an operating agreement.
An operating agreement sets forth the specific formalities a business will follow, and it helps identify and distinguish the actions of the owners when they act on behalf of the business, as opposed to when they act in their individual capacities.
4) Deviate or Avoid State’s Default Statute and Rules
An LLC that does not have an operating agreement is subject to the default rules set forth in its state’s governing LLC statute. These rules, while generally adequate, may not be optimal for your business. They are simple, one-size-fits-all, and not tailored to the distinct and/or unique needs of your business. Further, you may be unfamiliar with them, and, if a dispute arises, you will have to attempt to resolve it using default rules with which you have no familiarity.
Rather, business owners should take the time – or hire an attorney – to review these rules and customize more appropriate guidelines for their business and memorialize those in an LLC operating agreement.
5) Include a Non-Compete Clause
An LLC operating agreement also allows business owners to include a non-compete clause. Such a clause prohibits an individual from competing with the business for a certain period of time and within a certain geographic radius. It is designed to protect the business. The key with non-competes is to ensure they are drafted properly (by an attorney) so that they are enforceable.
6) Addition/Withdrawal of Members
The distribution of profits and losses is likely the most common area where disputes arise among members of an LLC, but the next most common area is the addition and withdrawal of members. Whether and how a new member can be added to a business usually raises question among existing members, such as how much that member must contribute to the business and what kind of voting rights that member will be entitled to (particularly, if the new member is younger than the existing members). Likewise, whether and how an existing member can withdraw from the business raises its own host of questions, such as whether and how that member is entitled to a buy-out and how that member’s interest in the business will be calculated.
I once litigated a partnership dispute that arose, in part, because one member terminated the other. The terminating member did not invoke any provision of the operating agreement. Indeed, there was none on which he could specifically rely. Further, the operating agreement stated – inexplicably – that neither member could withdraw from the business for three years. Instead, the terminating member attempted to rely on a provision that stated either member could be ousted from the business if he/she violated the law, and he argued that the terminated member had created a hostile work environment. That provision, however, was not clearly defined, and it did not describe what constituted such a violation. For example, did a violation of law mean an employment violation? Was a court ruling finding such a violation required before the member could be terminated? The provision was ambiguous and not helpful. If the members had agreed beforehand on specific instances when he/she could be terminated and included that language in their operating agreement, the time and expense of a lawsuit could have been avoided.
A state’s default rules contain general guidelines for the withdrawal and/or dissociation of members, but business owners can prepare more detailed – and favorable – guidelines for themselves in an LLC operating agreement.
Forming an LLC and filing the necessary incorporating papers with your secretary of state is an important first step in launching your business. Taking that all-important second step – drafting and signing an LLC operating agreement – is just as critical. If your LLC does not have an LLC operating agreement, you should contact a business attorney and consider how best to prepare one for your business.