Operating Agreements
Name a sport with no rules, or, try to imagine any business or complex organization, be it government or private, that operates without a set structure in place.
The only one that comes to mind is from the immortal comic strip known as “Calvin and Hobbes”. Calvin and his tiger Hobbes often play a ball-sport they affectionately call Calvinball, in which they make up the rules via a running dialog as they play. Its chaotic, confusing, and rather brutal. The strip always ends with the two exhausted and battered players lying in the grass questioning their own actions.
Sports without rules are doomed to failure. Try it the next time you play Monopoly. Also doomed to failure are businesses without a set structure in place. This is what the Operating Agreement is for.
Picture your Operating Agreement as the rulebook for your LLC. It explains how the LLC will be managed, how taxes are paid, how profits and losses are distributed, and who gets what when the company is sold. A good operating agreement not only informs everyone within the company of where they stand, it provides structure for its operations. Your Operating Agreement is by-far the most important document you will create for your business.
What does an Operating Agreement do?
Your Operating Agreement will define who the members of the LLC are and what percentage of the LLC they own. (this is also known as their membership interest).
Your Operating Agreement will define how the LLC is managed. Known as the members' rights and responsibilities, they will spell out who is responsible for what job duties within the company.
Your Operating Agreement will define how taxes are paid and who is responsible for the business side of the LLC.- Your Operating Agreement will cover or define such things as Capital Expenditures, Spending Authority, Loans, Credit Lines, Vesting Periods, and the Re-investment of Profits.
- Your Operating Agreement will define the members' voting powers and rules for holding meetings.
- Your Operating Agreement will define how profits and losses will be allocated.
- Your Operating Agreement will cover buyout, or buy-sell, provisions, which determine what happens when a member wants to sell his or her interest, dies, or becomes disabled.
- Your Operating Agreement will cover how the company may be sold or dissolved.
This sounds like a lot for a small LLC, especially if that LLC consists of only one person. There are good reasons for having one though, no matter how small your company may be right now.
Why You Need an Operating Agreement
While many states do not legally require your LLC to have an operating agreement, it's unwise to run an LLC without one, even if you're the sole owner of your company. Having your own Operating Agreement allows you to set the rules for your business, rather than letting your business default to rules set by the state. Your Operating Agreement will help you protect your limited liability status, head off any financial and management disputes, and make sure your business is legitimate in the eyes of the court. Should the courts find that you are running an LLC, especially a sole proprietorship, without an operating agreement, they may view this as a green light to deny the protected status your LLC was supposed to have and go after your personal assets.
You will also need an Operating Agreement to obtain services related to your LLC. Most of these services will require that they see your Operating Agreement to ensure them that you are complying with the law. Some of these services are:
- A bank to establish accounts and lines of credit for the LLC.
- A bank or lender if you are obtaining loans.
- A title company if you are purchasing or renting office space.
- Accounting and tax professionals for financial assistance.
- Bookkeepers for tracking of finances and payroll.
- Lawyers for legal advice.
- Potential investors or partners who have an interest in your business.
- Potential Buyers of your company.
NOTE: Unlike your Articles of Organization, the Operating Agreement does not need to be mailed to anyone. You do not need to mail it to the State, the IRS, or to anyone else. An Operating Agreement is what’s known as an “internal document”. It is only shared among the members of the LLC and the LLC’s lawyers, accountants, and bookkeepers. This means that you will keep a copy with your other business documents. Your Operating Agreement will not be listed in any public databases.
Legally Binding
An Operating Agreement is unique to every business. No two are exactly alike and there is no fill-in-the-blank form that you can complete, sign, and be done with. And even if there was, you would not wish to do that. The Operating Agreement is a legally binding document, and chances are good that you will need the language it contains at some point in the life of your LLC. For that reason we can’t provide you with step-by-step instructions for writing one. What we can do is cover all the areas that the Operating Agreement should have. Once you have all these requirements it will be easy to find a qualified attorney who can take your information and generate the document you need. Like editing and cover art, this is one of those things that is best left to the professionals. We strongly urge you to hire a lawyer to produce your Operating Agreement. In most states you can have this done for a few hundred dollars.
There are websites that offer this service as well. You simply fill out a detailed questionnaire and the service generates an Operating Agreement for you. These services are a bit hit-and-miss as far as quality, relevance, and detail, so we advise that if you are using one you take the finished product to an attorney for a final check before signing it.
What is required
In order to complete your Operating Agreement, you will need some basic information. Some is simple demographics, and the rest is choices that you and your fellow members will have made regarding the business and how you wish it to run.
- The Effective Date of your LLC.
- The name of the Registered Agent and the address of the Registered Office.
- The general business purpose of the LLC.
- Each Member(s) percentages of ownership.
- Names of the Members and their addresses.
- Each Members profit/loss-sharing percentages
- Vesting Schedules
- Meeting Requirements
- Management Choices and Definitions
- Areas of Responsibility
- Voting
And the multitude of other things.
A good place to start is to review these items with your accountant and make the needed decisions on each with their guidance before seeking out a lawyer to produce the final document. Many of the decisions needed are in relation to taxes and your states particular business requirements. A good accountant can help you pick the right options and save you valuable time and money when it comes time to visit the attorney.
TIP: Both the accountant and the lawyer’s services are tax deductible.
Key Items
These are areas that the members need to discuss and agree on.
Defining Financial and Management Structure
Multi-member LLC's need to document their Percentage of Ownership, Profit and Loss sharing, Management Structure, and decision-making protocols.
When an LLC is started, its members often contribute to it in a variety of ways. The members may invest cash, property, or services (sweat equity) to the business in its start-up phase. In return, each member receives a percentage of ownership in the LLC. Members usually receive ownership percentages in proportion to their contributions of capital, but this is not a requirement. LLC members are free to divide up ownership any way they wish. Ownership percentage is not required to match profit sharing, or “distributive shares”. The two are not required to correlate, it’s entirely up to the members themselves. These contributions and percentage interests are an important part of your operating agreement and the members should come to an agreement on these percentages before creating it or they might quickly find themselves ill-equipped to settle misunderstandings over finances and management.
Note: As mentioned previously, many states have a default rule that requires owners to divide up LLC profits and losses equally, regardless of each member's investment in the business. If you and your co-owners did not invest equal amounts in the LLC, you probably don't want to allocate profits equally. To avoid this, your operating agreement must spell out how you and your co-owners will split profits and losses.
Distributive Shares
In addition to receiving ownership interests in exchange for their start-up contributions, LLC members also receive shares of the LLC's profits and losses, called "distributive shares."
Example:
Bill and Tom decide to build a publishing company together. Bill had the original idea, is experienced in both business and marketing, and has saved enough money to finance the start-up phase. Tom is an author and has the needed library of books, a thorough understanding of the publishing world, and a network of fellow authors who are eager to have them publish their books. Once the business is launched they intend to share the operating costs and work requirements equally.
Since Bill is financing the start-up, handling the business side of things, and doing all the marketing, and Tom is contributing content and leveraging his network, they agree to a 60/40 split of the ownership of the LLC. However, looking ahead to the future and weighing the amount of work necessary to keep the company running and growing once it is launched, they see themselves equally contributing to its success. With that in mind they agree to a 50/50 split in regard to profits and losses.
If an LLC chooses to distribute shares that do not correspond to the members ownership percentages, this is known as a "special allocation", and will need to be defined in the Operating Agreement.
In addition to defining each owner's distributive share, your operating agreement should answer these questions:
What percentage, if any, of the LLC's profits must be distributed to LLC members each year?
On what schedule will these profits be distributed?
Who determines the amount of profit that will be re-invested in the company?
Will there be retirement or investment accounts that receive a percentage of the LLC’s profits?
Will there be any profits distributed to charity?
Will distributions be adjusted to take advantage of any tax benefits?
Will the LLC pay each member enough to cover the income taxes that member will owe on their annual portion of the LLC’s profits? This is important as an LLC owner has to pay income taxes on the full amount of any profits that are "allocated" to them, not just on the profits that are actually paid out. When profits are re-invested back into the business instead of being paid out, they are still treated as taxable income to the members.
Each member of the LLC will have different financial needs and related tax rates. It is advised that the members speak with a tax professional concerning this portion of the Operating Agreement in order to assure that it achieves the results that are most-favorable to each member.
Voting Rights
Most decisions made in regard to the daily operation of the LLC will not require a vote by its members. To do so would be disruptive to the day-to-day operations and slow any progress to a crawl. Most businesses decisions fall to the member who is responsible for them. However, certain limits should be placed on spending by all members. This prevents one member from spending money while the other thinks that money is available and spending it too, and thereby placing the company in debt.
Using our previous example, Tom, being responsible for producing the books and the support of it, would be expected to handle any hardware or supporting software purchases needed to keep that production going. He and Bill, who is running the business side of the LLC and keeping the finances in order, would agree on a spending limit they would both adhere to. If Tom needed something like a new laptop or some writing software that cost over a certain pre-agreed dollar amount, he and Bill would need to discuss it first. Likewise with Bill, who is handling the marketing for the business. He would have to consult with his partner Tom before spending over the monthly ad budget. This keeps both partners aware of what the other is doing, while at the same time assuring that the company remains solvent.
Note: Spending limits must have time limits attached to them. Otherwise it would be quite easy to simply spread out the expenditures in order to stay under the limits.
There are two ways to split voting power among LLC members:
Percentage Voting, where each member's voting power corresponds to his or her percentage interest in the business.
and
Per Capita Voting, where each member gets one vote.
Most LLC's mete out votes that correspond to the members' ownership interests. Whatever method is chosen, the Operating Agreement must specify how much voting power each member has, as well as whether a majority of the votes or a unanimous decision will be required to resolve an issue.
Ownership Transitions
Members of an LLC may come and go. The Operating Agreement should define what will happen if one member retires, dies, or decides to sell their interest in the company. This is referred to as a buyout scheme, and it covers the procedures the LLC will use should a member leave the LLC for any reason.
Changing the Rules
An Operating Agreement is a working document, meaning it can be changed at any time. Its purpose is not only to protect you and your business but to allow for your company’s growth. Simple changes such as a change of address for a member, or changing your registered agent, can be made yourself by modifying the original operating agreement and presenting the new version to the members for their signature.
More complex changes, such as one member leaving and another purchasing their interest, or the members opting to raise capital with investors, are best handled by consulting an attorney. Changes such as these can have a negative legal or tax consequence for the business if not done correctly.
Any modifications that are made will require the signatures of all members to make the changes legally binding. Signed copies should be distributed to all members and the LLC’s files updated with the new Operating Agreement.
NOTE: It is important to keep a copy of every version of your Operating Agreement, old and new. If there is ever a dispute it may be necessary to see what changes were made throughout the life of your LLC. Whenever the Operating Agreement is changed it is important to notify, in writing, every person who has one on file and send them an explanation of the changes made along with an updated copy.
One last thing
Operating Agreements are written in legalese. Commonly known as lawyer jargon, gobbledygook, and mumbo-jumbo. As such they can be hard to understand if one is not educated in such language. Now is not the time to be shy or to take things for granted. If you don’t understand a particular section or are unfamiliar with a term, NOW, before you sign anything, is the time to speak up and/or research until you do. Again, an Operating Agreement is legally binding. It’s a contract that you are making with your business partners, and the state your business is operating in, and you will be held to it. It’s important that you thoroughly understand what it is you are agreeing to before you sign.
