An operating agreement is the document that sets the rules for your LLC. You’ll be able to choose your management structure, lay out who’s responsible for what, and many other important issues. In this article, we’ll talk about how to create your own LLC operating agreement, what you should include, and where you’ll need to keep it when you’ve made one.
Should I have an operating agreement for my LLC?
The answer to this question is almost always yes. Although some states don’t legally require you to have an operating agreement, you really shouldn’t run an LLC without one.
Why exactly? Well, for starters, an operating agreement proves you and your partners are serious about running your business. That can really help with bank loans and holding onto your limited liability status, just in case something goes wrong.
If the rules aren’t written down, you might find yourself in a series of misunderstandings based on verbal agreements made months or years ago.
Additionally, an operating agreement will ensure that your LLC is run under consistent rules that you decide on. The rules in your operating agreement will serve as the foundation for your LLC, its owners, and its employees. If the rules aren’t written down anywhere, you might find yourself in a never-ending series of financial and management misunderstandings based on verbal agreements made months or years ago.
That’s never a happy place to find yourself in. If you don’t create an agreement, your LLC will governed by the de facto LLC rules in your state. That could lead to unfair profit splits, infighting, and a whole host of unpleasant issues.
Generic state rules also do not consider your unique circumstances or your goals for the LLC. With an agreement, you’ll know the rules you’ve applied to your business, so you won’t have to worry about the unpredictability of some obscure state rule applying when you least expect it.
What does an operating agreement cover?
LLC operating agreements cover a lot of very important topics. Most of the significant points covered by operating agreements discuss member’s business interests, their rights in running the business, and how the LLC will be managed. No two operating agreements are the same, so you’ll need to choose what’s right for your business.
Here are some things you’ll want to make sure you cover:
Generally, each co-owner’s interest percentage in an LLC is determined by how much money that co-owner contributed to the business when it started compared to how much every co-owner contributed.
There are other ways to split ownership, of course. For example, in your operating agreement you could give 30 percent ownership of your LLC to a co-owner who only contributed 10 percent of the property to the LLC.
There are a number of reasons you might do this—for example, you could incentivize owners who are doing more work to receive a higher percentage of profits—but the way you divide ownership interests ultimately depends on your vision for the LLC and your unique circumstances. Since this will affect who makes important decisions for your company, make sure you give ownership percentage a good deal of thought.
Sharing profits and losses:
LLC co-owners share in the profits and the losses of their LLC. The sharing of profits and losses is done through distributive shares. You’ll choose these percentages in your LLC operating agreement.
Another thing: You should address whether profits will be distributed regularly (like once a month or quarterly, for example) or withdrawn at will from the LLC by owners. If profits are distributed regularly, you’ll want to choose how much of the LLC’s profits will be distributed, and if any will be held by the company itself.
It should also be noted that LLC co-owners have to pay taxes on the LLC’s profits whether they’re distributed or not. Make sure to consider whether or not everyone will have enough money to pay taxes if they don’t have access to their LLC profits.
Management and company roles:
You’ll want to ensure that your operating agreement establishes a managerial structure for your LLC. A good outline for how your LLC will be managed and what your company’s roles will be is really the blueprint for running your business operations from day-to-day.
Address questions like: Will your LLC be run by its members or by a certain number of managers? How will decisions be made? Who will be making the decisions? How will you define your company’s roles? Will there be a board of directors? Who’s really in charge, at the end of the day?
You’ll also want to define the procedures used for making decisions in your LLC. Defining your LLC’s management structure and company roles avoids needless confusion and misunderstandings in the future.
Your LLC operating agreement can also specify your business’s method of accounting and the fiscal year your business will use. You should also consider hiring an accountant who will make sure your fiscal statements are prepared in accordance with GAAP or some other recognized accounting standard.
Operating agreements frequently include a provision requiring the LLC or its members or managers to disclose an audited balance sheet and audited statements of operations and cash flow to their LLC’s co-owners. This helps everyone stay on the same page and keep up with the business’s financial health.
Usually, the day-to-day business decisions of your LLC will be made informally, without having to put anything in writing or taking votes. However, if a decision will significantly affect the LLC, a formal vote is usually necessary.
You should equip your LLC with the procedures and rules that govern voting by describing them in your operating agreement. To avoid state default rules, make sure to address how much voting power each co-owner or director has.
For example, will each co-owner get only one vote? This is called per capita voting and it is a simple way of establishing voting power but not the only way. Voting power could also correspond with ownership percentage.
For an effective vote, you will need to decide whether a majority of votes is good enough to approve a matter or if a supermajority (66.6 percent) of shareholders must consent before a matter is passed. Unanimous decision-making is also an option, but you should speak with someone about the implications of required unanimous decision-making before deciding to choose this option.
Rules, of course, are different for solo LLCs. You should still take care to keep minutes when you make an important decision, just to be on the safe side.
No business remains the same forever, so it’s also smart to make plans in your operating agreement about what will happen if one co-owner leaves the business, voluntarily or involuntarily. You can take care of this contingency in your operating agreement or, if you’d rather, a separate Buy-Sell Agreement.
They work by requiring a co-owner to sell his or her shares to the other co-owners (or simply to have the sale approved by the co-owners), when the owner decides to call it quits. Decide how that will work, who can purchase an owner’s shares, and most importantly, who can’t.
Nobody invests in a business thinking that the business will end, but of course, it happens. Co-owners go their separate ways or the business fails to make a profit and eventually you might have to close up shop.
Though it might be hard to think about now, you should plan for the end of your LLC in your operating agreement. This is because you don’t want the default rules to apply to the ending of your business, especially at a time when it may seem that things couldn’t get worse.
At the very least, you should address what kind of vote will be required to dissolve the LLC and how you will split the final value of the LLC at the end of its life.
Can I change the operating agreement once my LLC has adopted it?
Yes. Every state has its own rules on how amendments can be made, but to take control of the amendment process, you should include it in your LLC’s operating. The provision should cover amendments, slight modifications, or revocation of the agreement altogether.
You’ll have the discretion in deciding how your LLC will be able to amend, modify, or revoke its operating agreement, though that’s usually done by a majority vote. If you do not include a process to amend your operating agreement in the agreement itself, you will be subject to your state’s default rules. Some default rules are as strict as requiring the unanimous consent of all members before an amendment to the operating agreement is allowed.
How do I create an operating agreement?
Creating an LLC operating agreement isn’t hard. Get together with your co-owners and a lawyer, if you think you should (it’s never a bad idea), and figure out what you want to cover in your agreement. Then, to create an LLC operating agreement yourself, all you need to do is answer a few simple questions and make sure everyone signs it to make it legal.
Have you got any questions about crafting your agreement? Any tips or advice to offer others?