Drafting an Effective Operating Agreement

Written by Steven Tennies on August 28, 2013 at 3:02 pm

While many states do not require you to have an operating agreement you will be far better off in the long run if you draft and adopt one. An operating agreement is an agreement between the owners (members) of a limited liability company that governs the company and outlines each member’s ownership interests and their financial and managerial rights and responsibilities. In function it is similar to corporate bylaws and partnership agreements.

The two most important reasons why your LLC needs an operating agreement

An operating agreement: (a) protects you from personal liability and (b) provides a framework that enables you to run your business efficiently and effectively.

#1: Personal liability protection

A limited liability company helps protect your personal assets. An LLC owner, known as a member, is not personally liable for the debts and obligations of the LLC simply because they are a member.

Unfortunately, this liability protection is not absolute. It can be challenged in a process referred to as “piercing the veil.” This occurs when someone sues your business and asks the court to set aside the LLC protection and hold you personally liable.

How do they accomplish this?

They try to convince the court that you did not treat your business as an entity independent from yourself, that you actually operated your business in your individual capacity. In other words, you ignored the LLC as a separate entity and ignored all the formalities of running your business as a business, meaning that you ran your business as a personal piggy bank.

Formalities? What’s that?

Formalities refer to the specific rules, tasks, duties, and responsibilities that must be followed to signal to outsiders that your company is a bona fide business. Some of these formalities, the high level ones, can be found in your state’s legal code. But most of these formalities, the nitty-gritty ones that make your company unique and distinguishable from you, are found in your operating agreement. Therefore, the best way for you to challenge the claim that you really ran you business in your individual capacity and preserve the protective veil is actually have an operating agreement and adhere to its provisions.

An operating agreement gives your company a personality of its own, with its own set of rights, responsibilities, and rules. Once you draft, adopt, and follow an operating agreement, you become an independent owner and agent of your company, which itself is separate and independent of you. Do this right and you can rest assured that you are protected against personal liability for your business debts and obligations.

#2: Framework to ensure efficient and effective business operations

An LLC is a creature of the state. It exists only because state law says it exists. Once you form your LLC it exists as a shell. What it needs are rules that dictate how it will function and operate as a legally distinct entity. These rules bring the shell to life and give it structure.

These rules make up the operating agreement. They inform the members, managers, and employees of what is permitted, what is forbidden, and what must be authorized to run the day-to-day operations of your company. An operating agreement signals to the world that the business is real and lets them know the terms under which the company conducts its business.

When you do not have an operating agreement your company rules default to the state law governing LLCs. Still, much remains uncertain and unclear. There is room for disagreement and confusion that could ultimately lead to a company shutdown. An operating agreement resolves all these potential problems and helps avoid disputes and misunderstandings among the business members.

Key takeaway: Drafting and adopting an operating agreement for your LLC is critical to your company’s success. Never operate your LLC without one, as this document governs how you will run your company.

Limited Liability Company Operating Agreement Essentials

Because the operating agreement is so important for every business you need to know what absolutely must be included in the document to avoid disputes and possible business failure. Look at the process of creating an operating agreement as an investment in your new business that will reap many dividends.

Get your company started on the right foot by building it on a solid foundation. The following essential components will help assure that you have a solid agreement.

#1: Make sure that your operating agreement is written.

If you don’t draft and adopt an operating agreement you subject your company to a set of default operational and governance rules set forth in your state’s legal code. The problem is that state law assumes that the LLC will have a written agreement with operating details. Consequently, state law can only provide generic provisions to address a given situation where more specific provisions are called for.

Don’t place the future success of your business at risk. But by subjecting yourself and your business to a set of generic provisions that’s precisely what you’re doing. And only when it’s too late, you’ll find out that most generic provisions won’t work for your business.

Let’s take a real-world example: Many state LLC laws state that members must share EQUALLY in the profits and losses of company, no matter how much each member contributes in terms of capital and services. But exactly the opposite is usually intended. Having a properly drafted and executed operating agreement would remedy this situation.

#2: Make sure that every member signs your operating agreement.

Since the operating agreement is the primary document that governs everything between and among the members you must make sure that every member signs the agreement.

The biggest mistake you can make is going through all the effort to prepare an agreement but fail to have every member and manager sign it.

#3: Carefully consider how your LLC will be managed.

When it comes to a multiple-member limited liability company, a common issue that arises is that at some point there are too many managers. Too many people have too much (or misplaced) authority to act on behalf of and govern the company.

The best time to determine the management structure of your multiple-member LLC is at the time of formation. In general, you have two options: member-management and manager-management.

A member-managed LLC gives each member the authority and right to manage and act on behalf of the company, much like partners in a partnership. Member-managed LLCs are the most prevalent. In fact, in the majority of states member-management is the default absent a contrary election in either the organizational document or the operating agreement. Member-management is usually most appropriate for a single member LLC. But as more members are admitted to the company it becomes a less attractive option.

A manager-managed LLC specifically appoints certain members or non-members to manage and act on behalf of the company, much like officers in a corporation. As your company grows, and especially when the number of members increases, a manager-management structure is often the better alternative.

Make the decision early on whether you always want every person admitted as a member to be an active, executive level manager. If not, a manager-managed company will save you time and spare you a lot of grief later.

#4: Clearly delineate relative member interest, contribution, and distribution rights and responsibilities.

More times than not, people get together and orally agree on a business venture: they discuss who will own what and who will do what. Then formally organize an LLC but never document, in writing, what they agreed to.

Time passes by. The business takes off. Memories fade. Members start to disagree. The Pandora’s box is opened.

So much time, money, and energy is wasted arguing about issues that were at one time agreed upon by everyone. Regrettably, the disputes give rise to lawsuits, and everyone loses except the attorneys.

The lesson: Document everything in writing. Clearly delineate, in exacting detail, specific and relative member interest, contribution, and distribution rights and responsibilities. Keep this current and up to date as new members come and go or whenever anything of substance changes amongst members.

Take the time and effort to make certain your operating agreement is properly drafted for your situation and signed by all the parties involved. Then, on an ongoing basis, make sure that it is appropriately amended and updated as your business evolves.

How to draft a great operating agreement

By now you should realize that your operating agreement is the single most important company document you’ll ever draft. Don’t make the mistake of using a poorly drafted agreement that is incomplete or worse yet, contrary to state law. It will leave you and your business wide-open for trouble later on down the road. Take the time now to learn about and understand the critical essentials you need to make your operating agreement the very best that it can be.

How long should it be?

In general, you want to strive for brevity and clarity. You want the shortest, most concise agreement for your particular situation, but not at the expense of necessary detail.

Your operating agreement must address a number of key issues. Therefore when it comes to length, your operating agreement must be long enough to address the all the major issues: management structure, membership, governance, tax, voting, profit and loss allocations, and other key matters.

Remember: your operating agreement is a practical, living document that serves as your company’s user’s manual. Avoid operating agreements that are too short. Brevity is indeed important, as is clarity, but never at the expense supplying sufficient detail to be comprehensive and meeting the required purpose it is being created for in the first place.

Should you use an agreement from another LLC?

If you think you can use another LLC’s operating agreement and adopt it as your own, you’re mistaken. This is the worst decision you can make. Your agreement needs to be tailored and customized for your particular business, not what was negotiated and designed for someone else’s.

Your best option: Use a model agreement form from a trusted source, drafted by an attorney experienced in LLC matters, and actually used by them in their practice.

Should an attorney review my operating agreement?

If there is one area where you would get your money’s worth with an attorney, it would be having one who is experienced in LLC matters review your operating agreement prior to adopting and signing it.

The benefit of a limited liability company is its flexibility. It can be customized for any number of business circumstances. But its flexibility creates some complications. So, if you want to avoid future misunderstandings and have some peace of mind, you need to make certain that your agreement addresses all relevant contingencies, and this is where an attorney can help.

At the very least, if your resources are limited and you cannot afford an attorney, take the time to learn everything you can about drafting an operating agreement, then thoroughly prepare and review your agreement prior to adopting and signing it.

5 matters your operating agreement must address

Make certain that your operating agreement adequately addresses these five matters. If you fail to do so, you put yourself and your company at risk.

#1: Who the members are

Identity each member, listing their name, current address, initial contribution, ownership interest, role, and the date they became a member.

#2: How much each member contributed

Specify the cash, property, and services each member contributed to the company in exchange for their membership interest.

#3: What additional contributions each member must contribute

If a member must make additional contributions to the company this obligation should be noted in the operating agreement. This ensures that your company is sufficiently capitalized and provides the means to legally enforce a member’s obligation to the company.

#4: Who the managers are

Identify who has the authority to manage and run the business and include the rules the managers must follow.

#5: What power and authority the company has

Third parties who want to do business with your company want to know that the transaction they are entering into is authorized.

They will want proof of who has the authority to sign on behalf of the company, what steps members must take in order to authorize the person to sign on behalf of the company and proof that these steps have been taken.