The most popular entity to form a business today is the LLC. Many business owners form an LLC by filing their Certificate of Formation with the Secretary of State. As far as forming a business, this is the proper first step, but the problem occurs when the second step isn’t taken. That second step is drafting an operating agreement to govern the internal affairs of the LLC. Today’s post details some of the benefits of drafting an operating agreement for your LLC.
What is an Operating Agreement? An operating agreement is a legal contract between the members of an LLC and the LLC itself. It typically spells out terms that detail the management of the LLC, distribution of profits and losses, and all other internal operations of the company.
Observing the Necessary Formalities Depending on the circumstances, failing to observe certain corporate formalities will result in a loss of the limited liability enjoyed by business owners of an LLC. The operating agreement is an important step toward observing the necessary formalities since it will spell out these formalities for you. With a well drafted operating agreement in place, it is much easier to distinguish your activities as an individual from your activities as an LLC member. This is especially true in the case of a sole member LLC. If an LLC’s activities, especially its banking activities, are commingled with the activities of other entities and individuals, you run the risk of losing your shield of limited liability.
Avoid Management Disputes and Roadblocks One of the major reasons why LLCs have become so popular is the flexibility in setting up the management of the business. You can include management clauses that allocate different managers different authority. For example, if you’re a business-savvy entrepreneur who has partnered with a tech-geek, you can allocate the management authority for marketing and financial decisions to yourself and the primary product research and development authority to your partner. This way, neither partner has his hands in an area that the partner doesn’t have the experience or knowledge to advance.
Also, your operating agreement should detail members’ voting rights. You can decide what voting rights each member has, and how decisions are to be decided based on different voting structures, e.g. unanimous or majority. Clear voting rights and management authority will help avoid management disputes and roadblocks when it comes to important decisions for your business.
Clear, Predictable Results One thing that every business owner enjoys is predictability. By failing to draft an operating agreement, your business will be governed by the default state laws, which vary greatly from state to state. You run the risk of having to solve a business dispute under the laws of a state that you are unfamiliar with. However, if you draft an operating agreement, the terms of the agreement will control the internal affairs of the business, including disputes. The operating agreement will designate dispute resolution, choice of venue and jurisdiction, etc.
Non-competes Another benefit of drafting an operating agreement is that you can protect your business by inserting a non-compete clause that can prevent members of the company from competing with the LLC. Your non-compete can be as broad or narrow as you’d like, as long as it is drafted properly so as to be enforceable. To learn more about non-competes, check out the Seattle Small Business Lawyer’s blog.
Member Withdrawal and Dissociation The operating agreement is important for deciding how member disputes are to be resolved, and how members can withdrawal (or be forced out) from the LLC. With no operating agreement, it can be a difficult mess to deal with when member disputes arise or when one member’s interests no longer align with the LLC and its other members. While state laws generally have default rules on withdrawal and dissociation, you can create your own rules for withdrawal that are more favorable to the LLC. And, depending on the nature of your business, you may want more flexible (or less flexible) withdrawal procedures. Drafting an operating agreement that includes these clauses will save you significant hassle down the road.
Check out our series on LLC Operating Agreements.
If you'd like to learn more about drafting an operating agreement for your business, or operating agreements in general, please feel free to contact me at firstname.lastname@example.org or (206) 745-5229.