Why Your LLC Needs to Have an Operating Agreement

Are you one of those know-it-all types who files for your own limited liability company without the help of an overpriced lawyer?

In most cases, the articles of organization filing (the document that forms the LLC) is straightforward and can be completed without a lawyer. However, the most important −and complicated− document that should be part of every LLC’s legal document package is the operating agreement.

An operating agreement is a document that states how the LLC will be run. Think of it as the constitution of the LLC.

Examples of key provisions included in operating agreements are as follows:

Voting:  Sets forth the votes needed to add new members, terminate existing members, amend the operating agreement, etc.

Ownership: States the owners of the LLC and how much each member owns.

Termination: Discusses how a member can be terminated from the company.

Right of First Refusal:  Some operating agreements allow the LLC to buy a deceased or terminated member’s share.  An additional component could allow the LLC to pay for the shares over time through a promissory note.

Non-Competes: Many operating agreements contain non-compete clauses.

There are two key reasons why operating agreements matter.

First, operating agreement help to establish corporate formalities. One of the primary reasons for the existence of the LLC as a type of legal entity is that the LLC protects its individual members from personal liability. There is an exception to that personal liability shield, however.

The exception −called “piercing the corporate veil”− allows the assets of the individual owners of the LLC to be reached based on the LLC’s actions. If you do not have corporate formalities, such as annual meeting minutes and an operating agreement, then your LLC is more likely to suffer having its veil pierced in a lawsuit, making your home, car, and life savings subject to a judgment. This rule applies to both single and multiple member LLCs.

Second, and of incredible importance to LLCs with more than one member, is that the operating agreement contains the rules of the LLC. Without an operating agreement, the law is silent on what is supposed to happen in many circumstances. This legal confusion in the absence of an operating agreement usually leads to expensive litigation that could have been avoided by having an operating agreement from the outset.