What is an operating agreement in an LLC?  Why is it so important to get it right from the outset of your company?

Key Takeaways about What is an Operating Agreement in an LLC:

• Generally speaking, the operating agreement details who owns the LLC, what the relationship between each owner (known as a “member”) is and the responsibilities of each member, how important decisions are to be made, how income or profits are to be divided or reinvested and even elections for tax purposes.
• The failure to carefully craft a strong LLC operating agreement as the company is being formed is one of the greatest risks to the success and survival of any new or existing LLC in California.
• Decision making should be clearly established and provisions, such as a Membership Interest Purchase Agreement or MIPA should be in place for those moments when life interrupts: dispute, death, divorce or bankruptcy.

Would You Play a Game For All Your Money That Had No Rules?

What is the purpose of an operating agreement in an LLC, and why shouldn’t your new LLC use a downloaded form or skip this important step altogether?

Let’s start with a simple question:  Would you play a game that had no rules, and if you lose you must give up all the money you have and half of what you will ever earn going forward?  Of course you wouldn’t.  If something is really important don’t you make sure it’s in writing?

The LLC operating agreement basically establishes the rules of the game. The LLC operating agreement establishes the foundation for your LLC and will guide it through all phases of business.  It will also prevent litigation and provide a smooth process for handling the unexpected challenges and surprises that come up for the business itself, as well as in the individual lives of the members who own the LLC.

Why the Operating Agreement in an LLC Matters More Than Most Owners Realize

When forming a limited liability company, many business owners focus on filing documents with the state. The more important document, however, is the operating agreement in an LLC. This agreement defines how the company actually functions, how risk is managed, and how disputes are avoided.

An operating agreement in an LLC should clearly address the following core elements:

• Ownership Structure
  • Who owns the LLC?
  • What percentage interest does each member hold?
  • How is ownership documented and tracked?
• Member Relationships and Responsibilities
  • What is the role of each member?
  • Are members expected to contribute labor, capital, or both?
  • What duties and standards apply to their conduct?
• Management Structure
  • Is the LLC member-managed, where all members act as agents?
  • Or is it manager-managed, with specific authorities delegated to a smaller group?
  • What authority does management have without a vote?
• Decision-Making Authority
  • What decisions require unanimous approval?
  • What decisions require a majority or supermajority vote?
  • How are deadlocks resolved?
• Allocation of Profits and Losses
  • How are income and losses divided among members?
  • Will profits be distributed or reinvested?
  • Are allocations tied strictly to ownership percentages?
• Tax Elections
  • Will the LLC be taxed as a sole proprietorship, partnership, S-corporation, or C-corporation?
  • Who has the authority to make tax elections on behalf of the company?
• Capital Contributions and Additional Funding
  • What happens when the LLC needs more capital?
  • Are members required to contribute additional funds?
  • How are new contributions valued?
• Admission of New Members or Investors
  • How is a new investor admitted?
  • What ownership interest will the new party receive?
  • How is that ownership interest valued?
  • What voting rights are associated with the new ownership stake?

These provisions are not theoretical. They govern what happens when growth occurs, when disagreements arise, or when outside investment becomes necessary. A properly drafted operating agreement in an LLC provides structure before conflict develops.

The Operating Agreement in an LLC and Limited Liability Protection

Another critical function of the operating agreement in an LLC is to reinforce the company’s limited liability structure.

Although the term “LLC” stands for “Limited Liability Company,” courts look at how the business actually operates when determining whether to respect the liability shield. Without proper documentation and separation, creditors may attempt to reach personal assets under theories that apply to sole proprietorships or partnerships.

A well-drafted operating agreement in an LLC helps establish:

• Clear separation between the business and the individual members
• Defined authority and boundaries for each member
• Formal acknowledgment of limited liability protections
• Documentation supporting the corporate veil

Separating personal assets from business debts and contingent liabilities is one of the primary reasons entrepreneurs choose an LLC (or any business entity). The operating agreement is the document that supports and preserves that separation.

In practical terms, the operating agreement in an LLC is not merely an internal document. It is a foundational legal instrument that defines ownership, authority, financial rights, and liability protection. When properly drafted, it reduces ambiguity, protects members, and provides the structural integrity that allows a business to grow with confidence.

The Failure to Craft an Effective Operating Agreement

The failure to carefully craft a strong LLC operating agreement as the company is being formed is one of the greatest risks to the success and survival of your new company. Why? The most common disputes that develop between the owners of an LLC are focused on one issue: Money.  Perhaps one member feels they are doing a lot more of the actual productive work and bringing in a lot more of the income.  What happens when one member wants to distribute some or all of the profits while another wishes to reinvest in the business to help it grow?

The operating agreement should also anticipate potential personal challenges such as what happens if one of the members gets a divorce?  Here in California a spouse could be given half of the member’s interest in the company during the divorce.  Do you want an ex-spouse to be a voting member or hold a substantial interest?  What happens if one of the members becomes incapacitated or passes away?  What if a member has to file for personal bankruptcy due to other factors outside of the LLC itself? What if one of the members wishes to sell their position in the company?  How will the ownership position of a member be established and would you want to make sure the other members have the right of first refusal to buy out another member if the situation arises?

A well-crafted operating agreement prevents all of these situations from arising and creates clear incentives and rewards for unbalanced workloads and earning situations.  Decision making should be clearly established and provisions, such as a Membership Interest Purchase Agreement or MIPA should be in place for those moments when life interrupts: dispute, death, divorce or bankruptcy.

These Are A Few of the Issues Which Make an Operating Agreement So Important in an LLC

These are just a few of the issues which make an operating agreement so important in an LLC.  The Watkins Firm has more than 40 years of experience in business formation and the crafting of important business documents such as an operating agreement.  We have a proprietary library of carefully crafted and proven successful contracts and operational documents.  We don’t have to create your operating agreement from scratch.  We simply need to review the (more than 100) separate potential clauses and components to tailor the operating agreement to your specific needs in a cost-effective and timely manner.

Why you should contact the attorneys at the Watkins Firm to help craft your new LLC’s operating agreement?  Our custom tailored agreements are competitive with downloaded forms, and you are able to draw upon more than four decades of genuine business experience here in San Diego and throughout the State of California.

Pro-Tip: The company documents, if you choose a corporation, should be tailored to your unique company and how you want it to conduct business, as well as the relationship between its owners.  Not all corporations are the same. If you choose a limited liability company, if you choose a partnership, a limited liability partnership, there’s all types of different variations. And then you can get into the nitty gritty based on your profession and all the regs and all the professional license requirements and all of the, depending on the kind of company, their resale license and permits. There’s all kinds of little things that your old business lawyer knows about <laugh> and can tell you about from the get go. As opposed to you finding out after you’ve made a few mistakes.

This process is a lot more than just picking an entity. You’re giving birth to a living creature that’s been recognized by the United States Supreme Court. And so what it means is birth is what we call capitalizing. And so you have these corporate documents and you have to decide on how much ownership will be and who owns what. Then you decide about what potential ownership there are. Reserve shares, I mean other ways in which people can own it. And then you capitalize it. Either you capitalize it with cash or you capitalize it with goodwill or a combination or a property. But how you capitalize it can determine whether or not it’s a real company or you have all those protections of corporate veil and creditors and you’re personally shielded. So how you start it is very important. And thinking about it, we’ll send you on the right path to avoiding all kinds of pitfalls and trouble.

And let’s talk about the corporate veil for a minute. Because the whole reason to have an entity is to separate you the person from the legal person of the business. That’s a big one. I mean, especially if you’re going to be doing some big business, you’re going to have big liability or you could personally not have big liability.

And also you can have an entity that can be sold. You can have an entity that can be sold in whole or bring in investors. If you do everything right, you get to do all these things. If you get a big opportunity and you didn’t set your company up correctly, then you can’t have your friend with an extra million dollars invest in your business. You’ve got to rewrite everything and you’ve got to restructure everything and you’ve got to hope you didn’t make any mistakes. And all of a sudden that opportunity doesn’t look like such a good deal. And that person who’s got the investment money will say, ‘well, this person’s not professional. This person’s not really serious about doing business.’ And you’ll miss it all because you didn’t pay attention in the beginning when you formed a company.

And the same thing for when a big company comes, knocks on the door and says, ‘Hey, we really like what you’re doing. We might want to buy you. And then they look behind the curtain and they say: ‘on second thought, we don’t want any on any part of this.'” – Dan Watkins, Founding Partner

Why is an experienced business attorney one of the most important advisors any company or business professional needs as a member of the team?  Learn how to protect your own interests and prevent litigation while openly discussing many common situations at a time when everyone is of one mind and working cooperatively together in the spirit of the new company.  We invite you to review our Podcast Episode 2 – Starting a Business, as well as the strong recommendations of our clients and contact the Watkins Firm or call 858-535-1511 for a complimentary consultation today.

Meet Daniel Watkins:

Daniel W. Watkins is a true people person who sincerely listens. He cares deeply about what others are going through.  Dan enjoys digging into the facts and finding creative solutions to problems.  He contributes his insights candidly and constructively.

Dan’s interest in people make him deeply invested in every relationship and his exuberant personality makes him a true litigator. Dan fights for his clients with a fierce and calculated commitment.

Dan has practiced in the areas of business, medical practices and healthcare business, high tech/science, real estate and employment defense law since 1987. He is a trusted litigation strategist and true trial attorney with over 50 jury and bench trials to his credit. Dan has successfully represented both large companies and individuals and achieved substantial victories in well-publicized trials throughout California and the U.S.

He is experienced in business and corporate formation and administration, as well as all forms of alternative dispute resolution, including binding arbitration and mediation.

THE ROAD TO BECOMING A BUSINESS LAWYER AND LITIGATOR

Dan has almost 40 years of experience working with, for and against some of the largest insurance companies in the country. He has successfully tried and litigated cases in the areas of Healthcare Compliance, Commercial Litigation, Unfair Business Practices, Fraud, Breach of Contract, Battery, Premises Liability, Product Defect, Medical Malpractice, Discrimination, Sexual Harassment, Construction Defect, as well as Unfair Competition, Defamation, and Trade Secrets.

In December 2003, Dan commenced litigation against Health South Surgery Centers-West, Inc and its’ subsidiaries, exposing the company’s extensive mismanagement and misconduct of its’ surgery centers. Dan has also been asked by some of California’s largest municipalities and corporations to conduct legally required investigations into matters involving alleged employment discrimination and harassment.