Top 3 Things To Know About Operating Agreements

Shaking hands in agreement

An operating agreement for a limited liability company (LLC) is essentially a “business pre-nup.” The owners are deciding in their own contract, in advance, how they will handle money and decisions during the business relationship and what happens when they break up.  Yes, “when” not “if.” Business breakups are inevitable because life happens. A strong operating agreement increases the likelihood that changes occur in an orderly, predictable, and desirable fashion.  While state law will provide default provisions in the event of a dispute, it is important that the owners have a customized operating agreement that addresses their specific business, prevents future conflict and keeps the business running smoothly.

Begin with the unexpected end in mind.

In addition to planning for exits, the operating agreement should plan for death, disability, divorce, bankruptcy, and other unpleasant circumstances we hope don’t come to pass. Basic planning tools should include buy-sell provisions, information flow to third parties (like heirs), and perhaps funding mechanisms through insurance policies. Upon these “trigger events,” the members would follow the plan minimizing the risk of any disputes.

Follow the money.

Few people go into business without the goal to make money, and most feel confident they will be able to make more money than they are investing as their capital contribution and sweat equity. The operating agreement addresses how the company will handle handle capital contributions, profits and losses, owner payments for work performed, loans between the owners and the company, and when and how additional capital contributions could be required. The topic of taxes looms large including what will the company’s tax status be, how will taxes be paid, and who is authorized as the “tax partner” for IRS purposes.

Making decisions.

Two flavors of LLCs are “member-managed” (where all the owners are able to act on behalf of the company) and “manager-managed” (where one owner or a hired manager is authorized to act on behalf of the company). If the LLC is member-managed, most decisions by default are made by a simple majority of ownership interests consenting to the decision. For both member-managed and manager-managed LLCSs, the operating agreement spells out what extraordinary decisions will be made by a supermajority and the percentage of the supermajority. Extraordinary decision include actions like taking on debt, making large or long-term commitments such as leases and employees, selling the company, and dissolving the company.   If such extraordinary decisions are not spelled out in the operating agreement, state law will supply a default which the owners may not like or want. Owners can and should determine how they want to make decisions in the operating agreement to supersede state law.

Takeaways.

  • Hire a good lawyer to craft your operating agreement just for you. The only “standard” LLC operating agreement we know is the type that is destined to fall short of expectations and end up costing more headache and expense in the end.
  • Be sure you understand what the operating agreement says and that provisions in different parts of the agreement are not inconsistent with each other.
  • If you have a cookie-cutter operating agreement, fix it while everyone is getting along and the stakes are low.

Natasha M. Nazareth, Esq.

Partner

240-202-4303
natasha@dmvbusinesslawyers.com

View all posts by Natasha