Updated: Oct 26, 2021
Do you have a Limited Liability Company (LLC) but never got around to drafting an Operating Agreement? Or, maybe you have one somewhere, but don’t really remember where it is, or what it says. Maybe it’s pretty outdated because while your company has evolved and you’ve added members, the document’s provisions no longer apply to your company’s current status.
Here are three reasons why having a current operating agreement is essential to the standing of your LLC.
Some States Require LLCs to Have Operating Agreements
The first reason, and the most obvious one in California is that having an operating agreement is a requirement. Other states such as Delaware, New York, Missouri and Maine also require LLCs formed or operating in these states to have one. Even if your LLC is not domiciled in one of these states, it’s still a good idea to execute an operating agreement because they instruct and guide how the business will be managed, outline the rights and obligations of the members, determine how profits will be shared among owners, set forth the rules for voting, making big purchases, contracting, etc., and can help to avoid expensive lawsuits down the road. This is true regardless of whether you’re a single-member LLC or a multi-member LLC.
Operating Agreements Help Owners Take Advantage of Flexible LLC Management
LLCs compared with other business forms are a newer type of structure and are extremely popular due to the operational flexibility afforded to the owners, known as Members. Aside from the requirement to have operating agreements, what goes into the document is where the flexibility comes in to play. Owners can use the operating agreement as the vehicle for designing the management structure, assigning the roles and responsibilities for key executives and personnel, outline how duties should be divided among Members or Managers, identify the initial or ongoing financial contributions of the Members, declare the proportionate ownership interest of all the partners, and so on. It's the ultimate roadmap and rule book. For example, sometimes partners in a multi-member LLC will contribute a disproportionate share of starting capital but want to share in future profits equally. The operating agreement can reflect these customized wishes. Or, members might desire to invest the exact same amount of starting capital but want future profits to be shared according to some other scheme. The Operating Agreement contemplates the decisions among the owners and lays the operational foundation for all aspects of the business.
As time goes on, and the business evolves, operating agreements can be easily modified to reflect the company’s evolution and growth, which may include the addition of new members, or the withdrawal of existing members, changes in management structures or responsibilities, financial considerations including distributions of profits, taking on new investors, or making tax elections to be treated as S or C Corporations.
No Operating Agreement Means the State Default Rules Will Decide
Perhaps the most important reason to have an operating agreement is also the most common cause for one of the biggest problems LLC owners face: The resolution of disputes will be determined by the state’s default rules when owners fail to not only create an operating agreement but to effectively address how disputes will be handled. An example of this that is often seen is that in a two-member LLC, formed at a time when things were much friendlier between the partners sometimes turns into something much uglier and contentious, leaving one co-owner threatening to withdraw membership and forcing the closure of the company in the process. In California, the remaining owner could previously bring a challenge with a court process, but the updated law allows by default a withdrawing member to force a dissolution of the company if a new agreement between partners for a buyout or some other resolution can’t be reached. That means all of your equity, efforts, intellectual property, current production and supply, assets and equipment, employees, could be cast to the wind. Hence, ugly.
With so many small businesses and entrepreneurs opting for automated business startup services instead of taking the important step of getting actual legal advice from attorneys before forming their companies so that they can better understand how LLCs work, owners are often subject to messy breakups, unintended tax consequences, lawsuits, loss of profits and goodwill, damaged reputations and ultimately losing the company they’ve worked so hard to build. Sure, you can always start over, but it's so much better - and cheaper - to avoid this.
For more general information about forming an LLC and creating or updating operating agreements, visit us at www.relatelaw.com.
This post is for educational purposes only. Nothing in this blog post is intended to constitute legal advice nor is any attorney-client relationship formed by accessing or sharing it.