The DNA of Your Business: Operating Agreements

This article is the second of a three part series regarding business agreements. The topics covered in this series are Partnership Agreements, Operating Agreements and Corporate Bylaws. This Article deals with Operating Agreements.

An Operating Agreement is a document used for Limited Liability Companies which lays out the manner in which the LLC will operate and function. Essentially the Operating Agreement functions as the bylaws for an LLC. Operating Agreements are only found in LLCs and is similar to a Partnership Agreement in that it will define the rights and duties of its Members. However, unlike a Partnership Agreement, an Operating Agreement will also cover broader terms regarding the operation of the Company and how it will work. Pennsylvania does not require that an LLC have an Operating Agreement in order to be legally recognized. However, many other states do require that such Agreements exist and you may be unable to do business in other states if your LLC does not have an Operating Agreement.
LLCs are a type of business entity recognized in the Commonwealth of Pennsylvania as well as nearly every other state in the United States. The owners of a LLC are commonly called “Members”. LLCs can be Member managed, in which the Members essentially function as Partners. LLCs can also be managed by a designated Manager, in which case the LLC may function more like a corporation which is run by officers rather than a Partnership. The Members of a LLC can be both passive and active, with some Members functioning like business owners who also run the business while other Members are little more than passive investors. LLCs are also unique in that they have a broad range of tax elections to choose from, a LLC can be taxed as a sole proprietorship, a Partnership, or may elect corporate tax status under Subchapter S or Suchapter C. Because of the wide range of options in how a LLC can be taxed and operated, LLCs are known for being extremely versatile.

Owners of LLCs may find that many banks require the existence of an Operating Agreement in order to open a business account for a LLC. It is also common that insurers, venture capitalists, lenders and financiers will require a LLC to have an Operating Agreement before they will do business with that LLC. The reason why these entities often require n LLC to have and Operating Agreement is because Operating Agreements give greater stability and safety to a business. Insurers depend on stable and low risk clients in order to stay profitable. Lenders and financiers will also seek out businesses which have lower levels of risk and greater functionality in order to make profitable investments.
Operating Agreements provide greater stability to businesses because they solidify the basic purpose, structure and procedures undertaken in the running of a LLC.

Since Operating Agreements are contracts which are binding upon the company, such agreements, if well written, will protect the Members of the Company and lay out the steps that should be taken in a wide range of events. Having such procedures put in stone greatly decreases the chance that the owners of a LLC will find themselves in Court or endure other disputes which may impact the functioning of the business. If you don’t have such things in writing, your chances of a damaging dispute occurring are much greater. Investors and owners of LLCs will have far greater protection if their LLC contains a well written Operating Agreement. Because of this, no sophisticated investor or venture capitalist will even think of investing in a LLC unless there is a solid Operating Agreement in place.

The process of drafting an Operating Agreement also helps the founders of the LLC to determine their vision of how the company should be structured and operated. While many businesspeople may share a common vision in what kind of company they want to create, or what industry they want to operate in, this does not mean that they share a common vision in how they want their company to deal with things such as resolving disputes among members, bringing in new owners or investors, choosing a tax election, dealing with the death or retirement of a member, or choosing how different responsibilities and duties in the company will be divided amongst its members.

The process of drafting an Operating Agreement requires business partners to talk about these things and come to an agreement on how certain events will be dealt with. If there is any disagreement amongst business partners about how certain tasks and events will be undertaken, it is far better to discuss these disagreements at the founding of the LLC, rather than having them arise after a business has been in operation and experiences these events.

Because of the versatility of LLCs Operating Agreements can take several forms. For example, if the Members of the LLC want the company to function like a partnership the Operating Agreement may differ little from a Partnership Agreement. However, if the Members of the LLC want their company to function more like a large corporation, the Operating Agreement may resemble Corporate Bylaws. Some LLCs may function more similarly to an investment trust, in which case the Operating Agreement may resemble a Trust Document.

LLCs have enough enormous versatility and can be used for almost any kind of business and business form. It is the versatility of the LLC that makes this business entity incredibly popular and the recommended form of many business experts. However, because of the versatility inherent to LLCs, business owners who do not solidify their LLC with an Operating Agreement are at a great risk of misunderstandings, ambiguity and disputes in the future. This risk is the reason why so many finance and insurance institutions refuse to do business with LLCs that do not have this level of protection.

If you are creating a LLC it is imperative that you draft an Operating Agreement upon starting out. While it is important for any LLC to have an Operating Agreement, it is especially important to have an Operating Agreement if the company is owned by several different people. Effective Operating Agreements can be affordably drafted by a competent attorney, and it is important to choose a lawyer who is both committed to value and has extensive experience in business formation and contract drafting. If you are thinking about founding a LLC and want to make sure your business is as strong as possible, or if you have already created a LLC and wish to ensure its ability to function, you should contact an experienced attorney who can help add value and stability to your company by drafting a well written Operating Agreement.

THE INFORMATION ON THIS BLOG IS FOR INFORMATIONAL PURPOSES ONLY AND IS NOT INTENDED TO BE LEGAL ADVICE. PLEASE CONTACT AN ATTORNEY LICENSED IN YOUR JURISDICTION BEFORE ACTING ON ANY OF THE INFORMATION CONTAINED IN THIS BLOG.