TOP 3 REASONS YOUR LLC NEEDS AN OPERATING AGREEMENT
I JUST FORMED AN LLC, DO I REALLY NEED AN OPERATING AGREEMENT?
Starting a limited liability company (“LLC”) can be an exciting and challenging journey. There are a number of steps to take and documents to prepare. LLC’s can be formed with just one member (that’s what an owner of an LLC is called) or multiple owners. Under the Illinois Limited Liability Company Act, a single member LLC is not legally required to have an operating agreement (though your bank may require one anyway). But if the LLC will have more than one member, one of the most important documents to create is the operating agreement.
WHAT IS AN OPERATING AGREEMENT?
An operating agreement is essentially an agreement about how the LLC will be run but also talks about what happens if a Member dies or no longer wants to be a part of the LLC and other exit scenarios. The operating agreement can be as simple or as complex as the members of the LLC want it to be. But be warned – leaving the provisions of the operating agreement vague or very basic can create a number of problems down the road (i.e. cost you thousands of dollars more to fix than it would have cost to draft a solid agreement in the first place).
WHY DO I NEED AN OPERATING AGREEMENT?
- Avoid Future Disputes Between Members
The operating agreement functions as a rule book, setting forth the rules for the running the LLC, dictating how actions are taken and who can take them. A well drafted operating agreement will establish a system that will ensure the business runs smoothly and that the day to day activities of the business will be handled efficiently. If a member wishes to exit the LLC (or the other Member’s want to remove a member) a thoroughly drafted operating agreement will provide a process for this so it does not have to be negotiated later (i.e.$$$$). If it is well written, it can handle internal conflicts and resolve any issues that arise without a lot of effort or fuss.
The operating agreement needs to be specifically drafted for the LLC, giving special attention to the company goals and the relationship between the members. It is extremely important to understand how the power and votes are distributed throughout the operating agreement and the ways the majority and minority members can affect or override each other. Besides determining the structure, focus and operation of the business, the operating agreement can be used to validate the corporate identity and to show that the members have been conscientious in establishing a legitimate business.
- Customize Your Business Structure
One of the best reasons to use an LLC rather than a corporation is the advantage of being able to customize how you’ll split profits, losses, work-load, voting rights and more. S-Corps or C-Corps are much more rigid structures and don’t allow you this flexibility to choose the roles and rights of each business owner.
For example, in a S-Corp, if you have 20% of the shares in the company, you will receive 20% of the profits or losses. Not only that, if one shareholder gets a distribution, all shareholders must get a distribution at the same time. An LLC allows you to set this up differently. For example, a 20% owner that actually does 80% of the work, can get 20% of the profits while getting a larger percentage of the voting rights (for example 51% or a controlling interest). Further a member that invests a large amount of money but wants a part of the contribution to be paid back before you begin to split distributions can get a preferred right to receive a certain amount (for example, Member A gets the first $50,000 of proceeds, after that all proceeds are split 50/50). While there are some limits to what you can agree to, for the most part the members are free to come up with their own arrangement as long as it is put in writing. Why do you have to write it down? Well…
- Avoid Your State’s Default Rules
If you do not create a written LLC Operating Agreement, you will be subject to your state’s default LLC rules. These are structured rules that do not provide the flexibility discussed in #2 above. It becomes “one size fits all” and not customized to your own arrangement. No matter what you’re buying, selling, or trading, your company is unique. You want the ability to shape your rules to fit the goals and hopes of your business. An LLC Operating Agreement allows you to do so.
OK, SO WHEN DO WE DRAFT THE OPERATING AGREEMENT?
While an operating agreement can be drafted at any time as long as all the members agree, it is best to draft the operating agreement as early as possible during the establishment of the LLC. Why? Because in the beginning everyone is getting along and optimistic about the business. Typically, decisions made at this point are for the benefit of all – wait until someone is upset and the decisions and positions they take will be for their own benefit. So it will be more difficult to agree on terms that work for all the member – and if agreement can’t be reached, then you could end up needing a judge to resolve you disagreements.
Waltz, Palmer & Dawson, LLC is a full-service law firm with various areas of service to assist your business, including: Employment Law, Intellectual Property, Commercial Real Estate, Business Immigration, Litigation and general Business Law services. Individual services include Estate Planning, Wills and Trusts, Probate, Guardianship, Divorce and Family Law, Collaborative Divorce & Mediation.
This article constitutes attorney advertising. The material is for informational purposes only and does not constitute legal advice.
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