There are a number of different situations where a LLC needs a document that sets out a list of rules and guidelines for dealing with disputes and mishaps.Such a document in business is an operating agreement. Like a contract, an operating agreement is designed to provide guidance on what will happen in the event of a business partnership dispute in various types of businesses.
This article is designed to make your understanding of an operating agreement simple, clear and more understandable.
Definition of the Operating Agreement
An operating agreement is an essential regulatory document usually drafted in the early stages of company formation, specifically the entities that fall under the limited liability classification. Similar in function to corporate bylaws, this document establishes the fundamental rules for managing an enterprise, its operational structure, key procedures, allocation of responsibilities, and other integral aspects of maintaining a legal entity.
Although its usages are somewhat superfluous for single-member entities, the document remains crucial for companies owned and managed by several partners. Its main function as a written contract between all involved parties is to establish and enforce the observance of authority and obligations assigned to each member.
The regulations, however, can extend beyond the officers of the company. They often tend to include general voting or meeting procedures, assignment of managers, registered agents, and staff, as well as the exact process of dropping, qualifying and taking on members.
How Operating Agreements Work
Unlike most paperwork involved in registering an entity or even maintaining it, this document is strictly internal and therefore doesn’t have to follow the same application rules. By the same token, there are no strict government regulations that mandate the creation of the agreement. That said, the majority of owners choose to do it and for a good reason—otherwise, running a smooth enterprise and regulating its financial operations with efficiency is a near-impossible feat.
The document itself typically goes through several drafts since all participating members must agree to the conditions outlined in each clause. The best time to prepare the agreement is during the registration itself. You can naturally keep it in-house or hire an attorney specializing in such contracts to help you flesh out the agreement. It must also be reviewed and signed by all members to have any binding power. It can and should be amended whenever any significant changes are made in the company’s structure, ownership group, distribution shares, and other procedures.
Why You Need an Operating Agreement
The underlying aim of this document is to help owners manage the entity internally and standardize its operations, though the latter is best approached with long-term regulations in mind rather than through the scrutiny of daily procedures. As it stands, the agreement’s central objectives are as follows:
- Enforcing liability protections: The document serves as further proof of the company’s structure that shields its members from unfair accountability charges tied to the entity itself;
- Upholding the rules of the arrangement: Although it’s legal to conduct the agreement orally, most owners understandably choose to preserve their contract in writing for easy access and later reference;
- Bypassing default laws: Each state has a set of default laws made applicable for any entity lacking its own internal regulations regarding specific procedures like profit allocation or company dissolution. Most of the time, these laws are very general and don’t account for the specifics of every individual entity. If you don’t have an internal document to support your company’s rules, your autonomy in relation to certain processes may be taken away in favor of a court ruling.
What to Include in Your Operating Agreement
Most government-mandated forms usually come with pre approved templates or specific regulations for their drafting. In the case of operating agreements, the structure and contents are left up to the owners. Although such a lack of restriction gives you more flexibility, it can also be a detriment when you don’t know how to tackle a concept as broad as company regulations. That said, despite the overall variety showcased by the agreements across the board, they tend to share a few fundamental clauses:
Capital contributions and percentage interest
When establishing a company, the founding and contributing members invest their money, services, or other assets to support the launch. This is called a capital contribution or investment and is often used as a basis for the distribution system, meaning that each member’s percentage interest—share of ownership—is calculated based on their contribution. Although this practice is common, a lot of the time the owners choose to divide their shares differently. The important part is to clearly outline the distribution process in the agreement.
This clause is usually included to help outline the allocation schedule out of the total shares attributed to each member. This includes the rules for withdrawal of assets (i.e. it’s a fixed schedule, owner’s draw, etc), compensation for personal income tax returns, and the permissible allowance from the total profits and expenses attributed to every member each year.
Organization, meetings, and voting
This section should focus on the type of management you choose for your company as well as the standard procedures for organizing meetings and the ways to notify members ahead of time. It should also outline the voting rights of all members and how many votes are required to make a decision. For instance, in some cases, companies adhere to the majority rule, while others accept changes following unanimous decisions only.
Changes of ownership and dissolution
Without setting your own rules for dismissing, replacing, and taking on members, you are taking a huge risk of letting your company be ruled by your state’s default laws. This is why it’s so crucial to describe each of these procedures in great detail. Aside from membership changes, you should also cover the transition of ownership such as inheritance or redistribution of shares as well as the steps that should be taken to oversee the dissolution of the entity.
Basic Provisions in an Operating Agreement
Although it’s technically up to you to decide what to include in this document, there are certain conventions that most owners follow to structure their agreements. More often than not, you will see the following points:
- Entity’s name: This provision identifies the company’s legal name as well as its registered, mailing, and office addresses;
- Statement of intent: A section stating the participants’ intention for following the agreement’s regulations under the federal and state laws;
- Company’s purpose: Here you outline the goals of your enterprise, its long-term objectives, and the purpose of its existence;
- Taxation system: This can be filled in following the decision you make during the formation itself. Specifically, this provision describes the company’s tax duties—whether it’s taxed as a pass-through entity or as a corporation;
- Duration: If you wish to put a limit on your company’s existence, state its foundation and termination dates in this section or leave it perpetual by default;
- Membership qualification process: In this clause, you can outline how to qualify, accept, and train new members.