Updated: Apr 23, 2019
Operating agreements are the governing documents of an LLC. They set rules for various issues a business faces during its life cycle. LLCs have become the most popular business structure, making it more important than ever for business owners to understand what operating agreements are and to take advantage of their value. Although operating agreements are optional, every LLC should have them and here are 4 reasons why:
1. Predetermines Business & Legal Issues
Businesses face many issues during their life cycle, such as:
i. Adding new owners/investors
ii. Daily operations and management
iii. Fundamental changes
iv. Transferring/selling shares
v. Owners leaving by choice
vi. Death or incapacity of owners
vii. Dissolving/selling the business
The operating agreement can determine how these issues are handled before they occur. This predetermination is valuable because it brings peace of mind to the owners that a specific outcome is certain to result. The agreement also ensures that the certain result will be easier and faster to achieve because a dispute over an issue properly addressed in the agreement will not go far. For those who need some financial incentive, the operating agreement saves more money than it costs every time a dispute is deterred or disposed of by the agreement. Lawsuits that go to trial can easily cost over $10,000 so a good operating agreement can save you this amount for each lawsuit that it prevents.
2. Bolsters the Corporate Veil
The corporate veil is the legal protection given by a business to its owners. That legal protection does not exist automatically just because you own a business. There is a five factor test to determine if your corporate veil can be "pierced", meaning that a person can hold you personally liable for something you did through your business. Two of these factors are the existence of governing documents and following the rules and procedures set by the governing documents. Since 40% of the test revolves around the governing documents, it is highly beneficial to actually have these documents (aka an operating agreement for LLC's).
3. Creates a Will for the Business
A will determines which one of your inheritors gets certain parts of your estate when you die. The operating agreement can do this for a business and its owners. The agreement does this by determining how shares can be transferred. This includes whether shares can be transferred to inheritors upon the death of an owner, whether an owner can unilaterally decide to sell their shares to a third party, and whether the company has the right to buy back any shares that owners seek to transfer. These provisions allow the owners to know where the company shares are going and prevent unwanted people from becoming owners.
4. Gives Solo Owners More Control
Solo owners can write an operating agreement before others join the company and start fighting for their own interests. If you plan on growing your business, you may have to part ways with some equity. It is also extremely common for a spouse to want to share ownership of a business with their SO. If you are a solo owner and think you might not need an operating agreement, consider this example:
You make distributions from your business to yourself in the amount of your personal tax bill and keep the rest in the business to grow it. You then take on an investor to grow your business even more. He splits his equity with his wife because they own everything together. Then, your spouse wants to split your shares. Now, you have to convince 3 people that you should require distributions in at least the amount of everyone's tax bill. If you fail, you won't have any money to pay your taxes.
By writing the operating agreement before any of these new owners join, you can require the tax distributions and the new owners will be forced to accept that fact when they take their shares.
An operating agreement is a valuable document that every LLC should have. If you have any questions or if you are ready to improve your LLC with an operating agreement, contact me today.