What is an Operating Agreement, and Why Does My LLC Need One?

What is an Operating Agreement, and Why Does My LLC Need One?

You finally decide to start that business with your best friend. After settling on the perfect name for your new limited liability company, you file the proper forms with the Ohio Secretary of State, pay the filing fee, acquire an Employer Identification Number from the IRS and open your company bank accounts.

The LLC is ready to launch and equipped to protect you from personal liability, right?  In the words of college football analyst, Lee Corso, “Not so my fast, my friend.”

Your LLC also needs an operating agreement — a contract between LLC members that outlines the ownership and operating procedures of the LLC and grants the members flexibility to create the terms they deem best to govern the internal operations of the business.  Think of the operating agreement as a pre-nuptial pact and your new company as the marriage.

In the absence of a written operating agreement, the provisions of state law govern the relationship between members and the operation of an LLC.  However, these statutory default rules leave many important issues open.

An operating agreement addresses specific potential risks or downfalls that many people tend to overlook and may help prevent an ugly divorce with respect to your LLC.  Without one, you may be doomed for serious litigation down the road.

Below are some issues that every operating agreement should address:

Member Contributions

Not every LLC member contributes cash up front. Some contribute expertise or services.  It is important to memorialize everyone’s contribution and explain the form and value of non-cash contributions. Additionally, this provision could detail how or whether any member should be repaid prior to any distributions, which would avoid confusion in the future.

Voting Rights and Management

Imagine going into business with one other person and encountering an issue on which each of you adamantly opposes the other’s position.  How will a resolution be reached if neither of you will budge?

The operating agreement tackles these situations up front and resolves conflict without eliciting confrontation in the heat of the moment.  The document’s flexibility provides for a creative solution that the members can create themselves.

Similarly, members need to decide if the LLC will be member-managed or manager-managed.  If a manager is hired, the members should specify in the operating agreement which actions a manager may take on the company’s behalf and which actions require member approval.

Transferring Membership Interests and Adding Members

One of the main reasons individuals go into business together is because they want to work with each other. However, suggest transferring your membership to an outsider as soon as possible and prepare for the onslaught of backlash from your fellow members. Likewise, when a new member is added, at least one member’s piece of the pie will shrink. As a result, not everyone may be on board with adding transfers or new members.

The operating agreement will allow members to place restrictions on transferring membership interests or admission of new members and spell out the procedures to follow if these instances arise.

Death or Bankruptcy of a Member

Most people do not want to think about their death or plan for their impending demise.  However, it is imperative that a business have a plan in case a member passes away—either expectedly or unexpectedly—or in case a member files for bankruptcy.  The operating agreement should address the method for handling these types of unsightly situations.  Otherwise, the remaining members run the risk of an undesirable heir, or even a creditor, becoming a member of the business.

Matthew Snyder is a lawyer in the Warren office of Harrington, Hoppe & Mitchell. He can be reached at msnyder@hhmlaw.com or (330) 392-1541.