If you’re about to start your small business, you probably have a long checklist of things to do. One of the most important parts of establishing your LLC is your operating agreement, which will act as the foundation for your business.
You have a lot of things to consider and decisions to make before you finalize this agreement. Here’s what you need to know about drafting your first operating agreement and how Mosey can help you stay compliant.
What Is an LLC Operating Agreement?
An operating agreement is a legal document that keeps everyone in an LLC on the same page. It details how the LLC will operate, make decisions, structure itself, and be managed.
It’s basically the terms of engagement for every member of an LLC. Once the document is completed, signed, and filed, every member of the LLC must abide by the terms of the operating agreement.
How Is an Operating Agreement Different From Corporate Bylaws?
Corporate bylaws are a set of specific instructions to enforce corporate structure and accountability in a C corp. Bylaws often govern large groups of people, including investors and shareholders. Bylaws are necessary because corporations often involve significantly more people than smaller LLCs, and a clear structure is necessary to keep things organized.
Operating agreements are a set of instructions for LLC members. They’re usually much easier to amend and less comprehensive because the actions of LLC members impact fewer people with decision-making power.
Who Needs an Operating Agreement?
Having an operating agreement is a smart business plan for every business entity. It has an enormous amount of utility in protecting members, settling disputes, assigning responsibilities, and promoting accountability.
Even though an operating agreement can be invaluable, it’s rarely a legal requirement. Most LLCs use their operating agreement as an internal document to dictate their day-to-day internal operations.
Only five states require LLCs to complete and formally file an operating agreement. LLCs in California, Delaware, Maine, Missouri, and New York are required by the state to file an operating agreement with the Secretary of State for legal compliance purposes.
Business owners in states that require an operating agreement must have one on file at the time of LLC formation. Their operating agreement must be completed at the same time as their Articles of Organization and business registration.
LLC owners in other states create operating agreements as voluntary acts of protection and internal organization for their businesses.
Why Draft an Operating Agreement?
Most LLCs aren’t required to draft an operating agreement. Even though there is no legal requirement for the majority of LLCs to do so, there are still many advantages to having your operational protocols clearly outlined on paper.
Empowering Yourselves
Most states don’t require an operating agreement for LLCs because they have their own LLC laws and rules on the books. If there’s ever a disagreement or a matter that needs to be settled, your LLC will follow your state’s default rules.
There’s a chance that no one will be happy with the outcome when the state makes all the decisions for them — having your own operating agreement empowers your LLC to make its own choices.
Minimizing Disputes
All relationships evolve over time, including working relationships. Responsibilities and levels of commitment may pivot in the long term. Your LLC may evolve into a completely different dynamic if you simply “go with the flow.” This can lead to burnout and frustration among LLC members.
If everyone’s roles and responsibilities are clearly outlined from the beginning, everyone is accountable for their actions. If you also include protocol regarding what to do if someone isn’t fulfilling their duties, you’ll have a swift way to settle any major disagreements.
Protecting LLC Members
Some LLCs may look like sole proprietorships if they don’t have an operating agreement that shows the number of people involved with the business and their responsibilities. However, there is a huge difference between an LLC and a sole proprietorship in terms of liability, and one of the biggest benefits of an LLC is the protection it provides.
Members of multi-member LLCs receive protection through their business, whereas sole proprietorships are literally their businesses. Sole proprietorships run significantly more risks in terms of liability because their business assets and their personal assets are often regarded as the same thing. If you want to fully enjoy liability protection and prevent your assets from becoming entangled in your business debts, an operating agreement can help.
Are There Downsides to Drafting an Operating Agreement?
There are far more benefits to drafting an agreement than downsides. Although an operating agreement provides a healthy amount of structure and responsibility, there may be some cases where an LLC operating agreement creates more obstacles than opportunities.
Agreeing Before You Have Experience
An ideal operating agreement should play every member of an LLC to their strengths by assigning responsibility to the people who are best equipped to handle it. If this is your first LLC with your group of members, you may not be aware of everyone’s strengths and weaknesses or have a complete picture of your LLC’s specific needs.
Without experience, it may not be clear where everyone’s strengths and responsibilities reside. If you assign clear roles in your operating agreement before you have a functional understanding of the way your LLC will run, you may wind up having to amend your operating agreement later.
Enforcing Structure May Impact Creativity
Passionate innovators and ambitious entrepreneurs may dislike operating agreements because they don’t leave a lot of room for creativity. When every procedure is clearly defined, an LLC is discouraged from taking creative or calculated risks. Startup founders may be hesitant to accept this kind of formality, especially if they intend to achieve something groundbreaking.
How To Draft an Operating Agreement
An operating agreement can be a lengthy document, depending on the amount of information you need to cover. It’s better to be very thorough from the beginning than it is to encounter situations later on that may be difficult to remedy if they aren’t covered under your operating agreement.
If you live in a state where operating agreements are mandatory, you need to include every piece of information on your written operating agreement. If your operating agreement is voluntary, you can focus on the most important elements of an operating agreement and elaborate on them as much as necessary.
You may also try viewing an operating agreement template to assist you.
Ownership Breakdown
Your operating agreement should detail how ownership interest in your LLC is divided among members. Some LLCs split ownership into equal percentages. Other LLCs may assign ownership percentages based on each participant’s desired level of involvement or capital contributions to the LLC.
Management Structure, Roles and Responsibilities
What is each member’s role within the LLC? What duties are they responsible for performing, and what powers do they have? How empowered are they to make specific decisions? Will everything need to be in mutual agreement, or will one member have unilateral power over certain matters?
Allocation of responsibility enforces accountability. Answering these questions within your operating agreement can prevent standstills or unresolvable issues when members need to make important decisions.
Profit and Loss Distribution
LLCs can choose how they’d like to distribute profits and losses among members. Distribution can be decided based on ownership percentage, roles and responsibilities, or each member’s desired level of involvement.
Meeting Frequency and Structure
Outlining the frequency and structure of your meeting in your operating agreement will ascertain that everyone is available when you need to touch base about important aspects of running your business. Officializing your meeting rules can also work to prevent members from making decisions without other members present if you want everyone to have an equal say in the way your LLC is run.
Member Admission and Voting Rights
Member admission refers to how new members will be allowed to enter the LLC, and voting rights will determine who has the power to make decisions for your LLC or influence its trajectory. This may not apply to the way you run your LLC, and you can omit this portion if it’s irrelevant to you.
Buying, Selling, and Transferring Ownership of your LLC
Information about how to handle a buyout, selling assets, or transferring ownership within your LLC is important. These decisions affect the future of your LLC, including whether or not you’ll still have a company tomorrow. If you have strong opinions about what should happen with your LLC in the future, it’s best to be as thorough as possible.
Tax Information
LLCs have several options for tax treatment and various ways to file tax returns. General information about how taxes should be handled and how tax responsibility should be assigned is equally important.
Having a trail that shows tax responsibility can protect members of the LLC in the event of an audit. It also holds members accountable for their role in paying taxes related to your LLC.
Do You Need Help With State Compliance?
LLCs of all sizes will encounter many compliance requirements. Several state laws require LLCs to draft and abide by an operating agreement. If you’re in the early stages of getting your LLC off the ground, there’s a lot you need to know. Let Mosey help you get the details in order once your LLC is officially formed.
Our compliance automation dashboard simplifies the process of meeting state compliance requirements. You can use Mosey as your official checklist to meet and maintain requirements as your business structure grows.
Schedule a demo with Mosey to learn how we can help you keep your LLC on the right track.
