All About Operating Agreements

All About Operating Agreements

An operating agreement is a document that outlines the internal rules and procedures for managing and operating a Limited Liability Company (LLC). If you don’t have a document that you and your partners have agreed to, then you’re at the mercy of the default operating agreement that’s provided by your state. Avoiding the state default rules is critical so you can decide how your business is structured, not someone else.

Benefits of an Operating Agreement

When you start a business with other people, it’s common to be too busy to worry about an Operating Agreement. The longer you leave it undone, the more issues you could face down the road.

An operating agreement makes crystal clear:

1. The ownership and management structure, such as the percentage of ownership held by each person, and voting rights. Being able to customize how your business is structured increases the chance the agreement is fair, especially when contributions to the business (start-up capital, time, expertise) is not equal.
2. The roles of the partners and who does what, to ensure jobs and tasks don’t cross over and employees know who to report to.
3. How meetings are run, what is included and frequency.
4. How profits (or losses) will be distributed based on risk and reward.
5. Salaries and bonuses.
6. How transfer of ownership can occur, when one person may want to leave, sell or they die. Often without an operating agreement, the LLC has to end.
7. If it’s possible to add investors or new partners over time.

It’s also wise to include the process when there is a dispute.

Protecting Your Limited Liability

One of the core benefits of an LLC is limiting your personal liability if something goes wrong outside your control to your personal contribution, avoiding wider LLC’s obligations or debts. If the worst happens and your business is liable for a loss, the court will look at your LLC to make sure the LLC wasn’t set up just to avoid personal liability. For example, if the LLC is really two sole proprietors and you’ve formed the LLC just for liability protection, not to run the business together, then regardless of being a LLC, your personal assets may be at risk.

An operating agreement helps prove that you have formed the LLC as a business to run as one entity, distinct from the members.

Avoiding the State Default Rules

A good example of most state operating agreement rules, is the equal division of profits and losses, which can put you at a disadvantage. You may not want the split of profits to be the same as ownership, for example, one person may have a larger percentage of shares but not work the same hours in the business, or work at all. In this case, you may want their distribution of profits less than their percentage of ownership. If a new member buys into your LLC, you may not want them to receive a full share of the profit immediately (as they didn’t shared the initial risk at start-up). Even more problematic, some state operating agreements require leaving members to be paid fair market value for their shares. Often, smaller LLC’s can’t afford to buy out departing members, or have to borrow the money to do so, which can cause the LLC to be dissolved. State operating agreements don’t tend to have the flexibility to cater for these situations.

Solving Future Disputes

Nobody thinks they will end up arguing with a business partner, but financial or strategic stresses can take their toll. When a difference of opinion occurs, it is important to have a clear and definitive set of written rules by which the disagreements can be resolved.

The failure to enter into a written operating agreement raises the possibility that a member could say there was an oral operating agreement, which is open to interpretation (and ‘you said’, ‘they said’). Even if you did promise something verbally at the start of the business such as ‘we’ll split profits evenly’, circumstances can change when this is no longer the case, for example, one member cuts hours to part time.

Any business that operates as an LLC should consider creating an operating agreement sooner rather than later. It will require an investment of time and money, but the benefits of creating your own clear set of written rules outweigh any associated costs.

Next Steps

• Discuss with the other owners of your business the need for an operating agreement.
• There is a Washington State eform you can complete which provides the basics. If your business was formed outside Washington, search your state here.
• LLC Washington have free Word or PDF operating agreements you can download to make a start.
• Contact your business adviser, accountant or solicitor to make sure you have everything covered. Filling in a template is fine to begin with, but isn’t the same as getting expert advice for your specific situation and customizing the agreement for what you want.

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