Why is an operating agreement so important in an LLC? What is the purpose of your LLC operating agreement and why shouldn’t your new LLC use a downloaded form or skip this important step altogether?
Would You Play a Game For All Your Money That Had No Rules?
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.
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. Are members going to manage the company as agents or will management of the company be entrusted to a smaller, specific group of people? Another common issue is the addition of needed capital or bringing on a new investor. How will this be accomplished? What ownership interest will the new party take in the LLC, and how will this ownership interest be valued? What voting rights are associated with each ownership interest, and how will an investor be involved when decisions need to be made regarding the direction of the company?
Another thing which makes the operating agreement so important in an LLC is the affirmation of the limitation of liability itself. Even though the LLC literally stands for Limited Liability Corporation, in many cases creditors can go after sole proprietors and partnership members for debts of the business. The operating agreement provides a straightforward and legally defensible opportunity to clearly establish and define the limited liability of each member. The separation of personal liability under the corporate veil from the debts and contingent liabilities of the business is a key element of selecting an LLC as an entity.
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 arises 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 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 Southern California.
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.
