Yes! You REALLY Need An Operating Agreement - And Here's Why
The telephone rang; it was a new client ranting about the other owner of his limited liability company (LLC) and asking for my help getting him out of the company. My first question was, "What does your operating agreement say about removal rights and how to value his interest?" Dead silence-then my client said, "We never got around to doing one because we were so busy with the business."
"Do I really need an operating agreement?" This is one of the most common questions asked by someone forming an LLC. The simple answer is yes. It is always best to have an operating agreement in place-period. If you don't and a dispute arises between you and your business partner(s), you may have a complex issue on your hands-perhaps one requiring expensive legal help.
Operating Agreement 101: What It Is & Why You Need One
An LLC is formed by filing articles of organization with the Arizona Corporation Commission. The articles only contain the most basic information such as company name, address, statutory agent, and names of owners (called members). The substance of an LLC is contained in an operating agreement. This document spells out in detail how the owners of the LLC will operate the company and handle their respective ownership interests.
Without an operating agreement, you are subject to certain state statutes. For example, if a dispute arises regarding the terms of your business relationship, these laws will override an oral agreement between the members. Members who rely upon an oral agreement are often at a disadvantage in future years.
Contributions, Loans & Profit/Loss Allocations
It is common for an entity to be formed with one member contributing all of the cash and another member contributing services. The cash-contributing member may later argue that the contribution was a loan to the entity-a loan that must be paid back to that owner before financial distributions are made to the other members. Without an operating agreement specifying whether the cash was a contribution or loan, the law usually presumes that the invested money is a loan when the initial member contributions are uneven.
Members who elect to contribute a certain percentage of initial capital but then decide to have a different determination of profits and losses must have this allocation stated in the operating agreement in order to avoid negative tax consequences. Because members can later disagree or change their minds on how the profits or losses are to be split, this issue often leads to litigation when there's no operating agreement in place. Without an operating agreement, profits and losses are assumed to be divided according to the percentages of capital contributed.
Protection for Minority Members, Multiple-Person LLCs & Single-Person LLCs
Operating agreements often protect minority members. Members who own less than 20 percent of the LLC do not have to be listed in the articles of organization. Therefore, the operating agreement is the only way to prove the exact ownership structure if there is a challenge between owners about the exact ownership percentages.
LLCs with more than one member especially need an operating agreement to permit a specific supermajority or unanimous consent of the members to approve loans, the sale of all the assets, revisions to the operating agreement, or changes to the company's structure. To protect owner interests, you can structure the agreement so a higher percentage than a mere majority is needed to make important decisions. Further, a majority owner may be at a disadvantage if there is no operating agreement, which provides that the majority owner has the control to make certain decisions by himself.
Even LLCs that only have a single member often need an operating agreement to do business. Due to increased banking oversight into the ownership of entities, banks are now commonly requiring operating agreements to open any business account in order to verify all the owners of an entity. With any loan transaction, a financing company will require inspection of the operating agreement to determine who has the authority to enter into loan agreements.
The "But We Get Along" Excuse
Don't fall prey to the common mistake of neglecting to create an operating agreement because your fellow business owners are friends, family members, or others you think you will agree with along the way. Business disputes can and do arise between members who don't initially envision that they will have differences on how to manage the company. Or, LLC members can remember oral agreements differently when a problem surfaces. In fact, some of the most intense business litigation occurs between family members.
Even if members do get along, the disability or unexpected death of one of the members may occur. In such a case, the probate of that member's estate will be unnecessarily complicated if there was no operating agreement confirming how to handle membership accounts, the rights of the estate to operate or vote on company matters, and the passing of the membership interest to heirs.
Membership Transfers & Termination Rights
You need an operating agreement to state how to handle transferring a membership interest from one member to another. For example, if a member can transfer his membership interest to a third party without restriction, the other members could end up having to work with someone they don't like. Strong operating agreements will prohibit most transfers without member approval.
Even if a transfer does occur, for example because of the death of a member, your operating agreement can prohibit the unapproved new owner from having any voting rights unless the new person is unanimously approved by the remaining members.
While you don't start a company expecting it to dissolve, it is vital that termination rights be decided and documented in your operating agreement. When in the middle of a dispute, you and the other members of the company aren't likely to have a good working relationship. That's why you need an operating agreement to specifically determine how to handle each membership interest and allocate assets between members. Without an operating agreement, members are forced to rely on negotiation and litigation, both of which can be time-consuming and expensive.
We hope you're convinced that an operating agreement is a vital and necessary element when forming an LLC. If you're a member of an LLC and don't have an operating agreement in place, it's not too late; you can and should create one as soon as possible. That way, when and if a dispute ever arises, you'll have the peace of mind of knowing you have a clear, enforceable agreement designed to protect your business interests.
For More Information
If you have questions, please contact one of our firm's Business Law attorneys below:
Christina M. Noyes - 602.257.7488 - firstname.lastname@example.org
Christina practices intellectual property, franchise and corporate law.
John L. Hay - 602.257.7468 - email@example.com
John practices intellectual property, corporate and franchise law.