The Role of Operating Agreements: An Essential Document for Every LLC
Starting a business is can be thrilling. But making sure it's protected is just as important.
For many small business owners, forming a limited liability company (or “company”) is one of the first big steps. But one key piece often flies under the radar: the operating agreement.
Think of it as your company’s legal playbook. It outlines how the business is managed, how decisions get made, and what happens if the owners don’t see eye to eye. Whether you're the sole owner or sharing responsibilities with others, having a solid operating agreement can go a long way in setting your business up for long-term success.
Ideally, an operating agreement should be adopted when your company is first formed. However, if you didn’t adopt one at the outset, don’t worry. It’s never too late to put a solid framework in place.
What is an Operating Agreement?
An operating agreement is a legally binding agreement between a company and its members that outlines the management structure of the company and establishes the rules for how the company will run. An operating agreement controls the relationship among the members of a company and establishes critical rules for succession planning and admitting new members. A carefully drafted operating agreement should address the aspects of the company that are important to its members and should be drafted to fit the company’s unique needs.
One of the most important benefits of an operating agreement is to provide clarity about the company’s operations and management structure. This allows the members to establish a clearly defined structure for how the company’s profits will be shared, how decisions concerning the company will be made, and how the overall business will run. Having consistent and identifiable rules helps avoid conflict amongst members and ensures that the company is operated efficiently. A carefully constructed operating agreement may also minimize the risk that a company’s corporate veil will be pierced, further protecting each member from personal liability.
What Is Included in an Operating Agreement?
There are several issues that a company’s operating agreement should address. However, the details of an operating agreement will vary greatly depending on the complexity and size of a company. Basic provisions that every operating agreement should include are:
Organization – An operating agreement should outline basic information about the company, including its name, registered office, purpose, term, and tax classification.
Membership – Every operating agreement should address the rights and responsibilities of a company’s members, identify the procedures that members must adhere to when adding or removing members, and set forth the meeting and voting requirements of the members.
Management structure – An operating agreement should identify how the day-to-day operations of the company will be managed as well has how “big picture” decisions must be made. This section typically identifies whether the company is member-managed or manager-managed and will explain in further detail how certain decisions can be made on behalf of the company.
Dissolution, Liquidation, and Termination - An operating agreement should set forth the procedures that a company and its members must follow once it is time to dissolve or terminate the company. Having these rules and plans set forth ahead of time will save the company and its members time and money in the future.
Does Every Company Need an Operating Agreement?
While most states do not require a company to adopt an operating agreement, it is highly encouraged for a company and its members to do so. Without an operating agreement, the company will be governed by the default rules established by the laws of the state in which it was formed. Although generally reasonable, default rules often fail to address individual companies' specific needs, intentions, and internal dynamics. For example, under South Dakota law, each member has equal rights in managing and operating the company, regardless of ownership percentage. Without a customized operating agreement stating otherwise, a member holding a majority interest may still need the consent of minority members to act, potentially creating unintended consequences and inefficiencies. By adopting an operating agreement, the members of a company can establish rules that suit the company’s specific goals and expectations and avoid the unintended consequences that the default rules create.
Additionally, while an operating agreement is most important for multi-member companies, even a single-member company should have an operating agreement. An operating agreement may also be required for the company to open bank accounts and to obtain loans. Furthermore, an operating agreement can establish a framework for how additional members can be added to the company and set forth the management structure of the company after additional members have joined the company. Having these procedures set forth beforehand ensures a smooth transition as a company grows and evolves.
Can an Operating Agreement Be Amended?
A company’s operating agreement can be amended and should be regularly reviewed to ensure that it aligns with the evolving needs and goals of a company. If the members wish to amend their company’s operating agreement, they will generally be required to adhere to the specific process for how and when it can be amended. If the amendment process is not identified in the operating agreement, the company must follow the default rules established by state law. Most states, including South Dakota, require unanimous member approval to amend a company’s operating agreement.
Conclusion
An operating agreement is an essential document for a company and, when drafted correctly, will promote the efficient and effective operation of a company. A properly drafted operating agreement protects members from personal liability, helps maintain a professional relationship among members, and guides a company through natural peaks and valleys. Woods Fuller has a team of experienced attorneys ready to assist business owners in starting their business ventures and to provide expert guidance as their business grows.