Should an entrepreneur draft or forgo creating an operating agreement for their LLC? It’s a question that weighs heavy on the minds of small business owners and with good reason. Most states do not require drafting written operating agreements, so entrepreneurs often skip creating the documents in favor of tackling more pressing issues.
However, since these documents ultimately define how the LLC will be run, it’s incredibly important to establish an operating agreement for your business. If you’re still not 100% sold on operating agreements, take a look at some of the long-term benefits it can provide your LLC.
1. Operating agreements are the framework of your LLC
Inside an operating agreement is comprehensive information about members’ rights and responsibilities, ownership rights, allocation of profits and losses, a plan for gaining and losing members, and an outline for dissolution. Without establishing this structure and its rules, it’s much harder to determine how to deal with issues that arise such as member disputes or what a departing member is entitled to (and vice versa for new members).
No operating agreement also means that things can only go from bad to worse for the business. When it’s bad, the state will question the validity of the LLC and enforce that the company is run by the state’s de facto LLC rules. At its worst, your LLC loses its credibility — and might even lose its status as a limited liability company too.
2. It works as a legally protective document
Entrepreneurs already know that by forming an LLC, your personal assets are protected with liability protection. However, if issues come up between members that leave you feeling concerned about your personal liability and the interests of your members, your operating agreement also provides legal significance in court.
How does this work? Operating agreements are legally binding and allow the court to see your company as a legitimate LLC. Once they make note of this, the court respects the document and allows the LLC’s owners to make formal decisions concerning the business.
3. You can be extremely detailed — and make changes! — when drafting an agreement
As I mentioned earlier, operating agreements are filled with comprehensive information. The more detailed and thorough you can be when covering key areas, the better it will be for your members.
Here are a few key areas to address in the following sections of an operating agreement:
- Members’ rights and responsibilities. Add in a division of labor to ensure each member knows what is expected of them. Detail information about how much say a member has in a business decision and plans for settling any disputes that arise between members.
- Ownership rights. Determine the percentage of the LLC each member is entitled to, how profits, losses, and assets are divided among members, and general ownership rights.
- Gaining and losing members. What happens when members leave and new ones come in? Each operating agreement should include details on what members that are leaving receive and what their future involvement with the business looks like as well as what new members get for joining.
- Dissolution. In the event of dissolution for the LLC, include detailed notes on how assets will be divided amongst members and if the members can establish and run businesses similar to the LLC that just dissolved.
Remember that once your LLC has adopted your operating agreement, you can still make changes to the document. Include a provision that covers how amendments and modifications are made in the operating agreement. Without this provision, you’ll have to rely on the state’s default rules for amendments so be sure to include this provision and review your operating agreement for any missing or inaccurate information before finalizing your operating agreement.