Starting a business without having a great LLC Operating Agreement is like trying to get to Disneyland without using GPS or map.
Not only will you probably have a difficult time finding your destination, but you're going to make unnecessary stops, experience various levels of frustration and spend more money than you budgeted. Here are some important facts you need to know about how Operating Agreements work, why they're important and what could happen if you don't have one in place.
What Is an Operating Agreement?
An LLC Operating Agreement is an instruction manual that outlines how you will run your business. Your Operating Agreement will define aspects of your business such as:
How the business is divided among owners (called "members" in an LLC): It can list what each member is contributing — like services or financial investment — and state what percentage of the business each member owns. This will also reflect how profits and losses will be distributed.
How decisions will be made: Perhaps the day-to-day functions are directed by the member who runs the hands-on part of the business, but bigger decisions are made by a majority vote or unanimous consent of all members. For example, if you run a real estate LLC, maybe the on-site real estate agent oversees the office manager, determines what loan officers to partner with and interacts with potential clients. However, if the company wants to change locations or considers investing in real estate property, then perhaps the Operating Agreement indicates that members need to meet to vote on whether the decision is in the LLC's best interest. You can find more tips for creating a real estate LLC Operating Agreement here.
What happens if a member needs to withdraw from the company: Whether from conflict or life changes, at some point a member may need to leave the company. An Operating Agreement will outline whether the member can only sell their portion to existing members or on what conditions a new member may be added. Additionally, this document will specify how the company will be dissolved if the business fails to make a profit or if the members no longer wish to pursue this endeavor.
Why Do I Need an Operating Agreement?
Most states don't require LLCs to have an Operating Agreement, but check with your secretary of state to see what the rules are. Regardless, even if you're the sole member of your LLC or your state doesn't require an Operating Agreement, it's beneficial to have one in place for several reasons.
It clearly defines your business as separate from your personal assets from a legal perspective: If your company acquires debt or is sued, you can feel secure knowing your home and bank accounts are protected. In certain circumstances, if an official Operating Agreement isn't in place, a court may view an LLC as a sole proprietorship, which can put your personal assets at risk.
It outlines what happens to your business if you can't run it anymore: If you're a sole proprietor, this is an important point to address. For example, if you don't put into writing what should happen to your business when you pass away, then the state will determine how your assets will be distributed.
It can help avoid messy lawsuits: Let's say you didn't have an Operating Agreement and you and another member decided to close up shop. Instead of dividing the assets based on who did the most work or invested more money, you may have to follow your state's default rules that require members to divide the profits and losses equally.
What Happens If I Don't Have an Operating Agreement for my LLC?
Now let's see what this could look like in the real world. Imagine that Jonathan, Susan and Monica open a salon that is an LLC, but they didn't create an Operating Agreement. Here are some instances where even things in an optimistic, friend-owned business could go terribly wrong:
John is taking a relaxing walk downtown and sees an open storefront. If he doesn't act quickly, he knows it will be gone before he can meet the other two members — so he signs a one-year lease agreement under the name of the LLC. Unfortunately, Susan thinks this part of town doesn't get enough foot traffic and Monica predicts the building will be too small to accommodate their needs. If they had an Operating Agreement, it may have specified that these types of decisions require a majority or unanimous vote of all members.
Susan and Monica just reconnected with their old high school friend Jenny who is a great hairstylist and is moving back to town. They decide it would be fun to have Jenny be a member of their LLC too, so they each sell her a portion. Unfortunately, they forgot that Jenny dumped Jonathan the night of the Senior Ball and they've hated each other ever since. However, without an Operating Agreement in place, Jonathan wasn't able to stop this decision.
Jonathan owns the bulk of the business now, but he's rarely in town and the three women run the company. However, the ladies failed to track receipts for products they purchased and hours they worked at the salon. When it comes time to split the profits, does everyone take an equal piece of the pie, or do more profits accrue to Jonathan since he owns more of the company? This should have been clearly laid out in an Operating Agreement.
While Jonathan is out of town, Susan, Monica and Jenny decide they're exhausted and not making enough money to keep the business going. They sell the business without input from Jonathan. How should the assets be distributed? What if Jonathan wanted to buy out his other partners, but they never gave him the chance?
While these are just examples of what could happen (every state has different procedures and rules), it's worth asking: Do you want to take such a huge risk as running your business without a clear Operating Agreement in place?
How Do I Create an Operating Agreement?
You could look up examples of Operating Agreements online, but you might not want to use a generic version of something this important that needs to be customized to your business. At Incfile, we can help you to draw up an Operating Agreement that addresses the most important aspects of running your business.
This service is included in our Gold and Platinum packages, or it can be added for just $40 to our Silver package. When you order a package, our legal experts will ask you questions and customize this document to your needs. Having a thorough Operating Agreement in place can save you time, money, legal complications and unimaginable frustration in the long run. The real question isn't Do you need an Operating Agreement?, but What are you waiting for?! Contact Incfile today to get started.