What is the purpose of an operating agreement?
Limited liability companies, or LLCs, are very attractive to small business owners, and for good reason: compared to other types of business entities, LLCs are easy to set up, easy to maintain, and offer increased personal protection. (Read more about LLC’s here.) Although LLCs require less paperwork than, say, an S corporation, they do require an operating agreement to be put in place.
What’s an operating agreement?
An operating agreement is a written document – typically 10 to 30 pages – that sets forth the financial and functional aspects and responsibilities of the business. Once the agreement is written, LLC members sign the agreement and are then bound by its terms just like any other contract. Arizona does not require that operating agreements be filed, but you should keep a copy with your attorney and in a central place where you keep important records.
The rules regarding the structure of the document are fairly flexible; in general, an operating agreement is written in such a way as meets the needs of the owners.
What elements are included in an operating agreement?
An operating agreement outlines a business’ internal operations by including the following information:
- Each member’s percentage of ownership
- Each member’s voting rights and responsibilities
- The responsibilities and powers of each member
- Distribution of the business’ profits and/or losses
- Information about business meetings, including frequency
- Rules regarding the transfer of interest in the business
Why does my LLC need an operating agreement?
There are three primary advantages to having an operating agreement:
Personal liability protection: The primary purpose of an LLC can be found in its name. It limits the personal liability of the members in the event of legal action against the company. The operating agreement acts to protect that limited liability status, and without it, it may be difficult to prove that your company is not simply a sole proprietorship or partnership, both of which can leave you exposed or held liable for damages brought against your company.
To put oral agreements in writing: Communication is imperfect at best. Ever try the “telephone game”? So, important agreements like operating agreements should always be put in writing so everyone knows what the deal is. Also, after it is signed, nobody looks at their operating agreement until there is a dispute about something. So, the operating agreement will be an important tool in resolving conflicts between the members of the LLC.
To avoid your state’s default laws: If your LLC does not have an operating agreement, default state laws regarding LLCs will be put into play. These laws are written in very broad terms to ensure they apply to a wide variety of businesses; as a result, these laws probably will not be ideally suited for your situation.
Is an Arizona LLC required to have an operating agreement?
No, but it is really dumb not to have one in place. Really expensive, time-consuming fights can be completely avoided with a thoughtfully drafted operating agreement. Some LLC owners forget to draft the operating agreement or try to save money by not doing it, and they almost always regret it sooner or later. You will spend more money in one day fighting with your partners than it would cost to just get the operating agreement put in place up front.
Photo Credit: Aidan Jones