July 24, 2020
Starting your own Limited Liability Company (LLC) is certainly an exciting venture for a business owner. You’ve either been in business for a while as a sole proprietor or with a partner and are now moving into creating a new business structure, or you’re starting a whole new business. Either way, you’re likely looking into a whole lot of new terms and structures you may not already be too familiar with.
Since you’ve opted for creating an LLC, you have taken steps to legally separate yourself as the individual from the company itself. This means should your business fall on hard times and go into debt or be sued, by and large, you won't have personal liability for the business’s debts. This ensures your personal savings account, vehicle, and real estate are largely safeguarded against creditors.
You’ve likely already picked out a great name for your new company. Just make sure to check with your state that the name is available and be sure to stick to the naming guidelines of your state. Also, this is a great point in time to check if a domain name is available for your company name. Even if you don’t plan to make a website immediately, you’re probably going to want one at some point down the road, so make sure you have a good site name available.
Next, you will need to choose a registered agent to act as the contact point between your company and the state. This can be a person or a company, they just have to be a resident of the state you’re opening in.
Once you have a unique name and an agent, you’re ready to submit your legal documents like Articles of Organization or Articles of Incorporation with the state. After this is filed, and you receive confirmation from your states Secretary of State’s office you’ll be allowed to start your small business!
Do I Need a Custom Operating Agreement?
In some states, like California for example, you’re required to also have an LLC Operating Agreement (although California does not require a written Operating Agreement (see Cal. Corp. Code § 17701.10(d), (g)), memorializing it in writing is in your best interest). While you don’t need to file this document with the state, you should createone. In areas where it’s not required based on the laws of your state, it is still highly recommended you draft one up at the outset of your LLC business formation.
This document is similar to the bylaws of a corporation and is the set of default rules and procedures that govern how your company will operate. Since each company is unique and each set of members of an LLC will have their own personal preferences for their business needs, you will need to create a custom Operating Agreement.
A simple Google search for Operating Agreements will give you plenty of PDF templates you can use. While these are a good place to start for research, they’re not going to fit the needs of every LLC. Cookie-cutter Operating Agreements can be missing important language you need for your business type or to comply with unique state laws in states like New York and Delaware, for example. For these reasons, you and your company’s new members need to create a custom agreement that you all are on board with and that will serve as a rulebook for how your business will be run.
You and your company’s other founders will be best equipped to formulate the outline, however, you will likely still want to have a lawyer look over this agreement to ensure you haven’t missed an important section or tried to vary rights in a manner prohibited by law, and to check that everything is worded clearly to prevent misinterpretation down the road.
What Needs to Be Included in an Operating Agreement?
There are no regulations that specify what needs to be in an Operating Agreement—in most states, they’re not even legally required—however, there are general guidelines and best practices for key clauses savvy business owners should include. Below we’ll go into some of the most common sections and why it’s important to have them when crafting your custom Operating Agreement for your newly formed LLC.
Basic Information
The opening sections of your Operating Agreement will need to provide the basic introductory information on your business:
The Company name: depending on the state you’re in, you may be required to append “LLC” or “Limited Liability Company” to the end. See, e.g., Cal. Corp. Code § 17701.08; Del C. § 18-102; NRS 86.171; Tex. Bus. Code § 5.056; W.S. 17-29-108.
Business Address: The main address of your LLC, or your headquarters if you have multiple offices.
Registered Agent’s Information: Provide the name and address of your Registered Agent.
Business Purpose: Briefly explain what your company does and what sector you’re operating in.
Articles of Organization Information: List when your Articles were filed and in which state.
LLC Duration: You may have a specific date until which your company will operate, but in most cases, and usually by default, your duration will be open-ended, marked here with “until dissolved.” See, e.g., Cal. Corp. Code § 17701.04(c); Del C. § 18-801(a)(1); NRS 86.155; Tex. Bus. Code § 3.003; W.S. 17-29-104(c).
Membership Structure
In this section, you will want to specify who the founding members are and how ownership is split amongst them. In the absence of an Operating Agreement, or if you don’t specify this here, ownership defaults to an even split.
Keep in mind, the way you split up ownership will determine how capital contributions and profits are shared as well.
Distributions
This part is all about the financials and how everything is split up among your members. It’s important to spell out the frequency with which profits will be disbursed, whether it is simply quarterly or by hitting special milestones that trigger an additional distribution.
Everyone loves the profits bit of running a business, but don’t forget to include a section on losses. What happens when your company loses money and how will this be absorbed by your members? Unless spelt out differently in your Operating Agreement, allocation of losses typically matches profit distribution.
Managing Your LLC
When founding your LLC you’ll need to specify whether your company will be manager-managed or member-managed. What this means is will all the owners, or members, have a vote, or will they appoint a manager to run the company on their behalf?
If it’s member-managed, does everyone get an equal vote? How many votes are needed to pass an action? Who all needs to be present to achieve quorum? All of this needs to be addressed in your Operating Agreement since each company will be unique in this regard. If you do not include this information in your Operating Agreement, voting will operate by the default rules set out in your state’s laws. What works for a company with three members will be very different from what works best for a company of 20.
If you opt for manager-managed, you’ll want to specify how long this person will serve, which decision they can make without consulting the other members, and establish a process for replacing them or removing them from this position, should the need arise. It’s also important to designate whether this person will be a hired employee or a member manager.
Raising Capital
How will you raise capital from your members? This is where you need to elaborate on the process of capital contributions from your members, or the money each person needs to invest to get the business going. If you need to raise more funds down the road, will the contributions be mandatory? If so, will it require a vote and how will you enforce this? These are all very important questions that need to be addressed and agreed upon at the start in order to avoid disagreements and potential conflict among members later on.
Withdrawing or Transferring Membership
At some point down the line, one of your members may choose to leave the company. You need to specify what happens to their ownership in this case. Will the company have the first option to buy back their equity, will other members have the option to purchase it, will you allow a departing member to keep their ownership, but simply limit their voting rights, or will you allow them to transfer their interest freely? All of this and more should be addressed in the Operating Agreement, as when a member is leaving is oftentimes when many conflicts arise.
Although it is difficult to think about, you may want to include a process for the transfer of ownership in case of the death of a member. While most state statutes provide default steps, those may not match up with the expectations you have for your company. Will ownership pass to the next of kin or will there be a buyout of their equity? Hopefully, you never have to deal with this, but if it does happen, having it spelled out will help make an already stressful time just that much more structured.
Dissolution
You’re just starting your company, so the last thing you want to think about is shutting it down. Unfortunately, you will want to establish the procedure for this at the outset, should you and your other members agree that ceasing operation would be in everyone’s best interest at some point. You should include what specifically will trigger the dissolution, such as a unanimous vote, and how the assets will be split up afterward.
Summary
Starting a business and running it is hard work. To ensure that all your LLC members are on the same page and to avoid potential conflicts due to misunderstandings later on, it’s crucial to have an Operating Agreement that everyone has agreed upon. While premade Operating Agreements are good as reference points, you’re going to want to create your own because every company is different. You and your members want to establish the procedure that works for your team and your own company. While you can draft an Operating Agreement in-house on your own, it’s highly advisable to at least have a business lawyer look it over. They will be able to advise you if there is a clause you may have overlooked, if you have attempted to limit rights prohibited by state statute, and ensure the language you used is clear cut to minimize misinterpretations.
Sources:
https://www.thebalancesmb.com/what-is-an-operating-agreement-for-an-llc-398645
