The Importance Of An Llc Operating Agreement

Small business owners throughout the country are overwhelmingly choosing the Limited Liability Company (LLC) as the legal entity of choice. This hybrid entity provides the liability protection of a corporation without the double taxation and fewer formal requirements, making it very attractive to small business owners who do not want nor need a board of directors, minute books, or annual meetings. For an individually-owned business, or one with unbiased a handful of owners and employees, it’s often an ideal choice.

However, many small business owners do little more than file the organization paperwork with their state. They beget that because there is no formal requirement for a governing document then it’s not necessary.

Nothing could be further from the truth. Every LLC, even if there is only one owner, should have an Operating Agreement.

An operating agreement for an LLC is much like bylaws for a corporation. The operating agreement sets out the rules under which the LLC wishes to be run. Without this document, any suitable matters that may arise concerning the LLC will be decided by a court under the general statutes of the state. If there is an operating agreement, then its provisions will be respected as a contract between the members.

There are several indispensable elements that every operating agreement governing an LLC should have. First, the operating agreement is the place to narrate the initial contribution of every member, especially if some members are contributing cash while others are contributing non-cash services, like a client list or marketing expertise. Without this type of information being recorded, in the event of a later content, the cash-contributing members will have a significantly greater chance of proving their ownership claims to the value of the company than the non-cash contributors. Think your best friend would never claim more than 50% of the business in a court of law when a business remark arose? Think again. It is for the protection of everyone that the value of the initial contributions be formally recorded.

Another provision that should be included in every operating agreement deals with the transferability of each member’s membership interest, especially in the event of death, bankruptcy, or even divorce or marriage of a member. If you do not want to risk finding yourself in business with your current business partner’s bratty son, you need to spot out the rules for and restrictions on the transferability of member interests. Without specific restrictions, most states allow for membership interests in LLCs to be inherited and be treated as property in divorce.

A kindly operating agreement also spells out the method that is to be used to allocate profits and losses and what are the rules for profit distributions. A general rule of thumb is that profits and losses are allocated along the lines of the value of the initial contribution of the members, and no distributions can be made unless all operating expenses and reserve amounts are adequately covered. By spelling out the rules in an operating agreement, then everyone can be assured of a fair allocation. It’s better than having to have the same conversation over and over when money gets tight. Write it down. Here are the rules. Follow the rules.

Finally, the operating agreement is where an LLC agrees to indemnify its members for losses and liability. It should also spell out the expectations of confidentiality of business information and protection of intellectual property. If there are any expectations that members will not compete with the LLC, the operating agreement can easily restrict a member’s right to pursue personal business opportunities that may conflict with the LLC’s business. This is often less restrictive than an individual covenant not to compete, but it is viewed favorably by the courts when those types of issues arise.

Drafting an operating agreement is a valuable part of doing business as an LLC.

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