How To Draft An Operating Agreement For Your LLC

When it comes to business, there is no shortage of paperwork that needs taking care of. Getting this right from the moment your business is conceived will act like a set of guard rails that lead you throughout your journey to commercial success. 

Of the myriad of rules, regulations, and agreements a company needs to follow, an operating agreement ranks among the highest priority for most LLCs. In this article, we take a look at how to draft an operating agreement for your LLC.

But first, what is an LLC?

The world of business is drowning in confusing jargon and acronyms that are enough to deter anyone from the outset. If you’re thinking “how on earth do I prepare my business?” we’re here to calm those nerves, teach you what an LLC is, and explain why they aren’t actually so scary. 

First things first—the acronym LLC stands for limited liability company. What this actually translates to is a legal entity that is formed to own a business. They prove exceedingly popular, especially with novice business owners, as they provide the same kind of protection (limited liability) as a more substantially sized corporation, but are more cost-effective and manageable to run. 

Essentially, an LLC should be the first point of call for any prospective business owners. This is even more true within industries that are prone to harm or dangerous activities like gymnasiums and sky-dive operators. 

Additional benefits to an LLC include:

• Asset protection: Revisiting the “limited liability” in its name, this removes your responsibility for debts or most other lawsuits. This protects you and your personal assets from being collected in the event of such a case coming to fruition. 
• Taxation: American tax law isn’t the friendliest, but LLCs ease this pain a little bit. LLCs enjoy the benefit of pass-through taxation, whereby the owners can pass profits and losses through their personal taxes. However, incoming tax regulations may reduce the benefits of these tax breaks for S corporations. 
• Simplicity: Board rooms, armies of lawyers, sweeping call centre floors, and more members of the compliance department than you can shake a stick at—yeah, you don’t need that for your first business. An LLC strips back unnecessary layers of staff and bureaucracy, focusing only on what you need. 

How about an operating agreement?

Now that you know what an LLC is, it’s time to dive into the kinds of bureaucracy you will inevitably have to deal with. Operating agreements are one of the more common you are likely to come across. 

As the taxation of LLCs is integrated with that of the business owner(s) or members, you need to outline the financial and taxation decisions of the business. What this does is give clarity to the involved parties in order to keep financial matters from being led astray. 

All members of the company need to sign the contract, and they are then bound by its terms. Operating agreements are only mandatory in five states:  

• California
• Delaware 
• Maine 
• Missouri
• New York

How to draft your operating agreement

Here are the key factors to assess when arranging your operating agreement: 

The ownership of the company

The issue of who owns what should never be left to verbal agreements. You need hard, legal documents to prove who owns what and how much. This ownership clause in an operating agreement legally confirms and outlines the distribution of assets, profits, and losses between the owners. 

However, this is all contingent on how the structure of the LLC is arranged. If there is only a single member, then naturally they would be responsible for 100% of all finance related matters. Being the sole owner is fine in many cases, though it is becoming increasingly popular, and even recommended, to share a stake in your business with other employees and contributors. 

Outline member rights and responsibilities

After establishing who owns what, it’s time to divide labour among those members. This is essential to identify what rights and responsibilities each member has. This should be broken down based on factors that include the portion of the business owned, and the skills that they bring to the table. On top of this, ensure you assign how much input each member has when voting on important business decisions.

The process for leaving and joining the LLC

No, this doesn’t relate to any bizarre initiation rituals but instead describes the formal process through which you enter or leave the business. Essentially, expect the unexpected, and be prepared for any surprises that arise. 

In the event that someone new is coming into the LLC, you need to know how to formalise that process. The onboarding process, incentives, and other things the new member may receive should be outlined in your operating agreement. 

There should be an equally strict process for anybody who leaves the LLC. Before preparing the rules, you will need to contact your state’s Secretary of State’s office to establish what needs to be done. If an LLC is single-membered, then dissolution would be required. Sometimes, there may also be grounds for dissolution in multi-member LLCs when members leave. 

Dissolution

Like anything, you can’t just set something up and walk away the moment you don’t feel like doing it anymore, leaving it to be somebody else’s problem. You need a plan for how this will play out, and again, who holds what responsibilities. 

What dissolution means is that a business is formally closed down in the eyes of the state. Where an operating agreement comes in is that it should detail the specific terms upon which the LLC will be dissolved. The two most important parts of this include: 

• Debt: Talking about debt is difficult, so having it in writing makes things much easier. You will need to establish what happens to your remaining assets once all of the debts have been cleared. 
• Future business ventures: What restrictions, if any, will there be on the future business practices of the LLC’s members? This stops members from immediately mimicking the previous business, and from stealing the idea, clientele, and contracts from the previous entity. 

While LLCs are not always required to hold an operating agreement, it is certainly recommended. Following the steps above can help you create an operating agreement that puts everything in order and protects you, and others, when or if unforeseen events arise.