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Why Your LLC Needs an Operating Agreement

Updated: Apr 10

An operating agreement (often called a company agreement or LLC agreement) sets forth the basic rules and regulations for the operation of your LLC. When you hire an attorney to form your LLC, your attorney will routinely recommend that you adopt an operating agreement as well (even if it isn't a formal requirement in your state).

But why? What if all the owners get along? What if the other owners are close friends or family? What if the other owner is your spouse? What if you're the only owner? What's the point?

This is a brief, non-exhaustive list of some of the reasons you will want an operating agreement (Note: "default rules" refers to the rules that your state impose on your LLC if there is no operating agreement):

  1. To maintain limited liability – An operating agreement is one of the formalities that many states (including California and Texas) will look for in determining whether or not to pierce the veil. Even if your jurisdiction does not require an operating agreement (for example, Texas does not explicitly require LLCs to have one), it's a formality that is easy enough to satisfy.

  2. To pre-approve procedures for dealing with conflict – An operating agreement provides the rules and procedures for the operation of the LLC. By adopting an operating agreement before a conflict arises, you narrow the number of issues that might arise, and you largely avoid one party to a dispute arguing that there was some oral arrangement.

  3. To establish membership interests – State default rules generally allocate profits and loses in proportion to members' contributions (Cal. Corp. Code section 17704.04; Tex. Bus. Orgs. section 101.201). However, if the contribution was not monetary (for example, real property), your operating agreement can set forth the value obtained for that property. The default rules may turn this into its own complicated dispute.

  4. To set forth your business structure – Is the member with the majority interest another LLC? Is the LLC meant to be the general partner of an LP? Is it member-managed or manager-managed? How many classes of membership? You will want to clarify these issues before forming your company, and if you have other members, it is critical to put these decisions on paper before a dispute arises.

  5. To define terms – An inclusive list of agreed-upon vocabulary If your industry has a particular vocabulary, you will want that reflected in your operating agreement. If a dispute arises and the only "writing" you have is a bunch of emails back and forth about "the property," what does that mean? Does "contribution" include services or only cash?

  6. To set forth the actual owners – The owners of an LLC are called "members," and you will want to spell out exactly who they are. Did someone loan the company money (they're just a lender), or was that a capital contribution (and now they're your business partner)? Are spouses also members? Even if it is clear early on, you will want to put these into writing to avoid disputes down the line.

  7. To identify the manager – In a member-managed LLC, the members manage the LLC. In a manager-managed LLC, you will have a designated manager (who can also be a member). If there is no written operating agreement, two people might both think they were designated as the manager at some point.

  8. To identify a qualifying individual for licensure – Some state licensing organizations require entities to have a qualifying individual in order for the entity to obtain a license. For example, California's CSLB requires that LLCs (and corporations) have a responsible managing officer, employee, member, or manager ("RMO") to obtain a license. This person is effectively the individual through which the entity is licensed. You may want this set forth in the fee agreement.

  9. To increase the value of your business – If you have been observing all of the needed formalities (including having an operating agreement, keeping minutes, etc.), then your business will look like a better investment to potential new members.

  10. Succession planning – Succession planning is the process by which you set your LLC up to continue after you are no longer with it. You could think of it as estate planning for your business, but it is more like estate planning for your interest in the business. The operating agreement can set forth when and how membership interests can be transferred (there are other documents that can be more helpful here, such as Buy-Sell Agreements, which I will address in a future post).

  11. Dealing with potential community property issues – Your operating agreement can stress that, although certain members may be married in community property states, that those spouses will not be entitled to management or control upon one member leaving. This is typically dealt with in a spousal consent, which is often included in the operating agreement (and signed by the spouse).

  12. Avoid default rules – Corporations Code (California) and the Business Organizations Code (Texas) have a set of default rules for the governance of LLCs. You probably have not read them. You probably have not seen them. Until now, you might not have even known about them. Obviously, you haven’t agreed to them. That is why you want to use procedures to which you and your partners have agreed. This becomes especially important if you sell membership interests to new members.

  13. Third party requirements – If you try to set up a bank account, ask for a loan, or transact through escrow, your bank, lender, or escrow agent might request that you provide a copy of your operating agreement. This is fairly typical, and it looks better to a lender or other third party if you can say “sure” instead of “let me draft some real fast.”

This list is not exclusive.

There are many good reasons to have bylaws for your corporation. The big ones in my practice have been 1) to pre-approve procedures for conflict resolution, and 2) to define the operating structure.

If your LLC does not have an operating agreement, bear these issues in mind before drafting one or having an attorney draft one. Make sure it reflects your understanding of how the LLC should operate. And make an effort to understand it.

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