Why Your Business Needs an Operating Agreement

October 26th, 2022, 12:00 PM

Why Your Business Needs an Operating Agreement?

Are you preparing to launch a new business? Are you and your partners getting ready to create a new LLC formally? If the answer is "yes," you need to know the importance of developing an operating agreement for your new business. If your new LLC has already been launched, don't panic: you can still create a workable operating agreement even after your LLC has been set up. In this post, we'll introduce the basics of operating contracts and then highlight why you should be sure to develop such an agreement for your new enterprise.

Introduction: The Basics of Operating Agreements

An operating agreement – also referred to as "shareholder agreements" for corporations – is a document that essentially outlines how a business will run and its ownership structure. An operating agreement will delineate the business's ownership structure – that is, how many partners have a stake and the exact ownership percentage of each partner. Furthermore, the operating agreement will also lay out how business owners will make certain executive decisions (i.e., voting powers and voting schedules), how business owners will manage the business on a day-to-day basis, how managers are hired and retained, compensation, and how partners may exit, capital contributions, distributions, and so forth. The operating agreement defines how the business will be owned, managed, and governed. 

Essential Items of an Operating Agreement

Although any given operating agreement's precise structure and contents will vary, all contracts will contain specific essential provisions. Here are a few items that will be present in every operating agreement:

Name / Address of the Entity: The agreement will spell out the official name of the LLC, along with trade names ("DBA") and the mailing address (or addresses) of the entity.

Statement of Purpose: The idea of purpose will provide a concise outline of the general nature of the business, its philosophy, and its general purpose.

Statement of Intent: This provision clarifies that the business complies with all applicable state laws and regulations and that the entity will officially come into existence when the formation documents are filed.

Tax Treatment: As all taxpayers know, tax treatment is critical, so this provision will state precisely how the entity will be taxed (i.e., as a passthrough or non-passthrough entity).

Acquisition of Membership: This section will define how existing owners may add new members to the business's ownership structure.

Again, these are just the provisions included in (nearly) every operating agreement, but a given agreement will likely contain many more conditions. For instance, most contracts have sections on capital contributions (i.e., the initial contributions made by founding members), additional contributions, dissolution (i.e., how the entity may be dissolved), member meetings, and so forth.

Reasons Why Your LLC Needs an Operating Agreement

There are many reasons why LLCs need operating agreements, but the most critical reason is the prevention of disputes among members. The operating agreement clarifies the ownership structure of the business – i.e., how many members and which members have what percentage of the company – and defining the ownership structure in this manner goes a long way toward preventing disputes. More often than most people realize, LLC members frequently engage in disputes regarding their correct ownership share, and conflicts are much more likely when the LLC lacks an operating agreement. 

In addition, operating agreements help ensure that members are protected from personal liability for business debts. Furthermore, operating agreements ensure that the default state laws don't end up governing the LLC. Without an operating agreement, various default state laws may ultimately determine how certain events unfold, such as how profits and losses are divided; most LLC members want to avoid this possibility so that an operating agreement can resolve this matter. 

Contact Rust Belt Business Law for More Information

If you'd like to learn more, contact Rust Belt Business Law today by calling us at 814-983-6061.

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