After living with an idea for a business, in some cases for many years, you finally take the plunge and start your own business. This is an exciting time in any businessperson’s journey; however, it can also be a stressful time as there are a number of factors you must consider when setting up your new business.
Along with the name and structure of your business, one factor you must keep in mind is the need for an operating agreement.
To help you in drafting this document, this post will review what an operating agreement is, why it is important, and what information you should include in one.
What is an operating agreement?
An operating agreement (OA) details a number of important structures, processes, and procedures related to the operating of a business.
An OA is typically used to govern a limited liability company (LLC) and the relationship between an LLC’s members. Similar to the bylaws of a corporation, an OA acts like a company constitution through which members’ rights and duties are defined.
Some examples of what an OA can include are:
>each member’s roles, rights, duties, and entitlements
>detailing membership interests
>detailing capital accounts
>how profits will be distributed
>how liabilities will be allocated
>member and company tax responsibilities
>rules of daily operation for the company
>how voting works
>how (or if) new members will be admitted
>how the company will be dissolved (if necessary)
Beyond these example areas, an OA also functions as evidence that members intend to operate as separate legal entities and minimize their personal liability.
Why is an operating agreement important?
An OA is an extremely important document for any business as it documents a business’s structures, processes, and procedures regarding how the business and the business’s members will operate.
Further, in the event that an OA fails to include a relevant clause or point, and a member disagreement arises, state statute may take over to fill in the gaps in the OA.
Therefore, it is important for whoever prepares the OA to have long and detailed discussions with all members to make sure the OA represents the wishes and understanding of every member.
What information should you include in an operating agreement?
Now that you understand what an OA is and why it is important for your business, what should you include in one?
There are a number of general areas that most OAs cover, regardless of the type of business it pertains to.
However, it is important to note that the OA for your business should be tailored to your business and its needs. Our post today is simply a guideline for you to use when drafting an OA. The final document for your business should be thoroughly researched and tailored by you for your business.
With that note in mind, below are some of the more important areas to include in an OA.
Management: Who and How
One of the most important aspects of running a business is deciding how your business will be managed and who will be responsible for that management.
In general, one or two people can manage the daily operations of a business. Managers can also be officers of the business.
An OA details who the manager(s) is, what their duties are, and what authority is given to them. This last factor is extremely important since managers can have a wide range of authority over your business and business decisions depending on what you include in your OA. For example, some OAs give managers the authority to bind an LLC to a loan or other liabilities.
Classes of membership
You should also define what classes of membership are covered in your business. Classes of membership can include voting members, non-voting members, and/or economic interest members.
By documenting the classes of members in an OA, you are agreeing that all parties involved understand their roles and required contributions to the business.
For instance, you can have voting members who contribute equal capital. You can also have members who contribute equal capital but who cannot vote. You can also have economic interest members who enjoy the profits from a business, but who are not involved in voting, decision making, or the operation of a business.
Capitalization and additional contribution
Funding for you business is not only a necessary element in being able to run it, but it is also important to maintain the limited exposure of personal liability to all parties involved with an LLC.
If your LLC is undercapitalized, creditors may be able to pierce the corporate veil in order to hold a member or members personally liable for the LLC’s debts.
Board meetings outline and schedule
The more communication between members of an LLC, the better its operation and success will be.
Board members are encouraged to have at least one board meeting every year to make decisions and ensure the business is going in the planned direction.
Voting by members is the main pathway for decision making in an LLC. As such, how voting will be conducted, when it will occur, and what will happen in certain voting circumstances is important to detail in an OA.
For an LLC, there are two popular styles of voting: majority and super majority. A majority is usually anything over 51% of members voting in favor or against. A super majority is usually 67% (two-thirds) of members voting in favor or against.
An OA should detail which form of voting the business will use and the procedures for whichever form is chosen.
There is also an option to require a unanimous vote in order for a decision to move forward; however, this pathway is not recommended.
Finally, your OA should also define what will happen should a deadlock occur during a vote and members cannot come to a consensus.
New member admission
In this section of an OA, define whether new members can be admitted to the business, as well as any restrictions or conditions, if any, on the admission of new members.
Transfer of membership
At some point, a member may wish to transfer their member in your business. It is important to detail if transfer is acceptable and how that process will occur.
In LLCs that allow transfer of membership, transferring to an immediate family member is customary. Transfer to a third-party, however, usually has more restrictions, which are outlined in the OA.
Death of a member
Unfortunately, planning for worst-case scenarios is important in business endeavor, and that includes what happens in the case of a member death.
Some questions that are important to consider are:
>What happens to the deceased member’s membership interest?
>Does the interest go to an estate, family member or the deceased, or do other members have the right of first refusal?
Planning for an unfortunate event will keep you and other members from being caught off guard and scrambling to find the proper path forward.
Distribution of profits
As all business owners hope, hopefully your business will become successful and begin making a profit.
How and when those profits will be distributed is important to document in an OA.
In general, profit distribution is at least once a year, and is usually based on what ownership percentages each member has.
Finally, although you may feel that your business will last forever, it is important to plan for the possibility that you or other members may want to dissolve the LLC in the future.
In such a case, the decision for dissolution is usually undertaken as per the voting agreement for the LLC. If the voting requirements are met and the decision is made to dissolve, then members can appoint a member or ask a manager to oversee the dissolution process.
As previously stated, this post is merely a guideline for some of the most commons aspects of an operating agreement. The final details and specifics of any operating agreement should be carefully worked out and tailored to your business and needs. Consulting with a business attorney can help you in hammering out specific details of an operating agreement for your business.
Note: This post was originally published on 11/1/16 and has been updated as of 10/22/19.
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Disclaimer: Nothing in relation to the enclosed information should be construed and or considered as legal advice for any individual, entity, case, or situation. The following information is prepared for advertisement use only. The information is intended ONLY to be general and should not be relied upon for any specific situation. For legal advice on your specific situation, we encourage you to consult an attorney experienced in the area of Immigration Law.