What is an operating agreement and do I need one?
An operating agreement is an internal document that outlines how a limited liability company will be run. Basically, it includes everything the founders want to document about how to run their business.
Operating agreements can include all kinds of provisions, including specifics about when and how distributions are declared, who will serve as the managers, how to call member meetings and the extent of liability and indemnification for managers, to name a few. As we’ve mentioned in other posts, LLCs are fairly flexible entities and require less formal structure than corporations. Operating agreements document how the business will be run and managed so that everyone is on the same page.
Do I need an operating agreement?
Short answer: Yes.
There are many reasons why an LLC should have an operating agreement.
An operating agreement formalizes and documents the intentions of the members and managers. LLCs are governed by state law, and the law differs from state to state. North Carolina allows for operating agreements to be verbal, so a spoken agreement is enough to create an operating agreement in the absence of any written document, but this is a terrible idea. What if one party is unwilling to uphold the verbal agreement? It could turn into a fight over who said what and waste a lot of time and money on lawyers trying to find a path forward. A written operating agreement is more efficient.
Without an operating agreement, state law will govern the LLC. There are some specific provisions of state law that can’t be changed by the operating agreement but lots of things can be supplemented or changed entirely by the operating agreement. For example, without an operating agreement, all members of a North Carolina LLC are automatically managers and have equal rights to participate in the management of the LLC and act on behalf of the LLC in the ordinary course of business.
This could present a problem if the founders want to limit what certain members can do on behalf of the LLC. What if one member wants to leave the company? Can that member sell to anyone or do they have to offer their interest to the other members first? What happens if the sole manager resigns? Are all members entitled to the same voting rights? Who owns what and how did they contribute to the LLC? What happens if the members can’t agree on a specific course of action?
All of this can, and should, be outlined in the operating agreement. When everyone agrees, no one sees the need for an operating agreement; when things go wrong, or stakeholders simply don’t know or don’t agree on how to handle a particular governance issue, they should be able to look to an operating agreement. The terms of that agreement should be formalized while everyone is on the same page.
Finally, an operating agreement establishes corporate formalities that allow members and managers to ensure they are able to take advantage of the liability shield provided by the LLC. Without limited liability, individual members and managers could be personally liable for the debts of the LLC. This means that creditors could seize personal assets and use those to offset liabilities owed by the LLC. To prevent this, the LLC needs to maintain certain formalities (such as holding annual meetings or having a separate business bank account) which are established in the operating agreement. Once an LLC has an operating agreement, it should be followed to ensure limited liability protection.
What if I’m the only owner of the LLC?
Owners of a single-member LLC may not think an operating agreement is important. They are running the business on their own and don’t have to worry about anyone else making decisions on behalf of their companies. Preserving limitation of liability is still critical.
And, if the owner wants to bring anyone else (even their children) into the business and gives each child a small percentage of the company? All of the above issues still apply. For example, even members who own a small interest in a North Carolina LLC can still act on behalf of the company without an operating agreement.
Individual founders should also be aware that they probably won’t be able to sell their company without it. Sophisticated buyers know all of the potential issues we’ve identified here and will almost always require an operating agreement. Some banks require a copy of the operating agreement before they will open a business account for the LLC.
While the idea of having another legal document may be overwhelming, a good corporate lawyer can help make the process easier. Operating agreements are internal governance documents and they aren’t filed online with the Secretary of State. It’s well worth it to speak with an attorney about how an operating agreement can help your LLC going forward.