Four Reasons Why You Need an Operating Agreement
An Operating Agreement (or an Owner’s Agreement) is a document that governs the internal operations of your limited liability company. It outlines the equity and management structure, limitation on liability, books and records, and the process for dissolution of your business. While only a number of states require an Operating Agreement, it’s still crucial you have one.
As you’re reading this, I’m sure you’re thinking “Okay, but do I really need an Operating Agreement if I’m the sole member of my LLC? Wouldn’t I just be making an agreement with myself? It seems unnecessary.” At Marti Law Group, we believe in transparency with our clients, which is why we’ll tell you— “Yeah, you really should have an Operating Agreement in place, even if you’re a single-member LLC.” Here’s why:
Proof of Ownership
So, you’ve formed your LLC with your respective Secretary of State, but who owns your business? Your Articles of Organization or Certificate of Organization may indicate that you are the registered agent or that you are a member or manager of the LLC—but it does not declare ownership. While it may seem obvious, a question of ownership may arise if you ever choose to sell your business to a prospective buyer, as they’re going to want to ensure that you actually own it (makes sense, right?) An Operating Agreement will define the percentage of ownership a party has of the business, and if you choose to add members in the future, this will be essential.
The most common reason entrepreneurs choose to form an LLC is, as the name states, limited liability. Liability tends to be the subject that many small business owners fear. Starting your own business is costly and potentially opening up your personal assets to liability is daunting—so, cue the LLC. Generally speaking, an LLC protects your personal assets (your home, car, bank accounts, etc.) from creditors and potential breach of contract suits. In order to preserve this limited liability protection, it’s essential to keep your business affairs separate from your personal affairs and to maintain general business formalities. Maybe you’ve heard of the infamous “corporate veil”, which is the device that “shields” you from personal liability. The most common way to “pierce the corporate veil”, is to commingle funds or for failure of the LLC to exist independently from its members. Both commingling and the lack of a clear delineation between business and personal matters can risk a creditor getting around the liability protections of an LLC and going after your personal assets. Since Operating Agreements are unique to LLCs, without observing this formality, it’s possible that your business could resemble a sole proprietorship instead (which lacks traditional LLC protections). Fortunately, an Operating Agreement can both set forth business formalities to show that you are treating your business like a business, and not as an extension of yourself, and it also helps to create a separation of the LLC from yourself.
Prevents the Application of Default State Rules
If an LLC does not have an Operating Agreement in place, or, the Operating Agreement is silent on an issue—the default rules of the state in which the LLC was formed will apply. States generally adopt rules that would be beneficial to the average business owner, but that doesn’t necessarily mean it is beneficial to every business owner. For example, some states have adopted a rule that automatically gives a family member the right to inherit the assets (or even the management) of your LLC in the event of your own incapacitation or death. This rule may be satisfactory to some but may not be to everyone. Imagine a scenario where you are incapacitated and a family member with no knowledge of the business steps into your shoes as the new manager! An Operating Agreement provides you with the ability to dictate exactly how you want your business operated, sold, managed, etc. If an Operating Agreement is silent, or doesn’t exist, your state fills in the gaps to how your business operates (and you should really be the one in control of your business, right?).
Required by Most Banks
This might be news to some, but many banking institutions will require you to provide them with a copy of your Operating Agreement in order for you to open a business account with their bank. The general reason for this is because banks want to ensure that your business is legitimate, operating for a legal purpose, or that you have the authority to open the bank account on the LLC’s behalf. Having an Operating Agreement now could save you some time (and frustration) than if you waited until the bank requests it.