If you’ve recently formed an LLC, you should congratulate yourself on completing the important first step of choosing a business structure. However, keep in mind that there are additional items that should be on your checklist as part of the formation process. One of these is the operating agreement.
Note that California is one of the few states that legally requires LLCs to have an operating agreement. But, there are a number of benefits these documents provide even if you live in a location where they are not mandated by law.
What is an Operating Agreement?
With that in mind, an operating agreement sets forth the rules for how the organization will be run by its owners (referred to as “members”). The agreement outlines the rights and obligations of each member, establishes how decisions will be made and specifies how profits and losses will be divided.
Now, while there are a number of key terms to include in any operating agreement, the document should be tailored to meet the unique needs of your business. For this reason, it is important to reach out to an attorney for advice on these matters rather than using a generic form template.
Interestingly enough, in California, operating agreements can be verbal. However, these oral contracts are not recommended as they can cause conflict over what rights and responsibilities were discussed and agreed upon between the members.
Note that operating agreements are confidential and maintained by the LLC. This means that you do not file this document with any California agency.
Essential Terms to Include in an Operating Agreement
While each operating agreement will be different depending on the needs of the particular business, the following is a list of the most important provisions you will likely want to include:
- The name and address of your business
- The purpose of the business
- The duration of the LLC – the company may end on a particular date, after a certain event, or last until members dissolve the LLC (i.e. indefinitely)
- The name and address of the registered agent
- The tax status of the LLC – an LLC can be taxed as a partnership, sole proprietorship, or corporation
- Whether the LLC is member-managed or manager-managed
- The powers and duties of each member
- The percentage of ownership for each partner
- A schedule for member meetings
- Any restrictions on members – examples would be confidentiality or covenant not to compete agreements
- Allocation of profits and losses
- How major decisions for company will be made, such as by majority vote or unanimous agreement
- The manner in which disputes between members will be resolved
- Under what circumstanced the company can be dissolved and how assets will be distributed following dissolution
Bear in mind that each of these terms can be amended by the members at a later date. For that reason, its also important to include terms describing how the LLC can go about amending parts of the operating agreement (such as by majority vote or unanimous consent).
Benefits of an Operating Agreement
As mentioned, operating agreements are legally required in California. However, there are inherent benefits that make these contracts a good idea for any LLC, regardless of where your business is located.
For example, not having an operating agreement means that members risk losing liability protection. This is referred to as “piercing the corporate veil” in the law and means that you or the other members of the LLC could be held personally responsible for the debts of the business.
In addition, operating agreements help to minimize conflict between members. This is expeciually important when it comes to financial matters, such as profit sharing. Further, a bank may require an operating agreement in order for you to an account or obtain a loan for the LLC.
Finally, these agreements provide proof as to who owns the company and clarify what the purpose of the business is. Note, however, that all of the advantages mentioned above only apply to written, rather than verbal, operating agreements. This is because the terms of oral contracts, while generally legal, are incredibly difficult to prove.
Operating Agreement for a Single-Member LLC
Now, if you are running a single-member LLC, an operating agreement may seem unnecessary. However, keep in mind that California law still requires these documents regardless of how many members your organization has. But, the agreement will likely be different and more simplified in comparison to those needed for a multi-member LLC.
Also, remember that one of the major benefits of an operating agreement is that it creates separation between you and the business. This is important from a liability protection standpoint. In addition, if something should happen to you and you become unable to run the company, the terms of the agreement can dictate what happens to the business during your absence.
This is known as a succession plan and you may designate someone else to run the company. You may also choose to dissolve the LLC. Without these terms in place, your family may be tasked with operating the business for you, which may be a burden that you didn’t envision when you formed the organization.