Why You Shouldn’T Neglect Your Operating Agreement
If the Articles of Organization is the document that gives life to your LLC, the operating agreement is the heart and soul.
Let’s talk about your LLC's “operating agreement.” Perhaps the most overlooked step in forming an LLC is preparing the operating agreement. Arizona does not require a company to have an operating agreement. This is true in some other states as well. But most attorneys would agree that it is foolish to run a multi-member LLC without one.
The operating agreement outlines the structure of the company, including financial and working relationships. A.R.S. § 29-3105 . With some limited exceptions that will be discussed later, the operating agreement governs all of the following:
- Relations among the members as members and between the members and the limited liability company
- The rights and duties under this chapter of a person in the capacity of manager
- The activities and affairs of the company and the conduct of those activities and affairs
- The means and conditions of amending the agreement
The operating agreement may contain any provision that is not contrary to law. Talk about flexibility. But wait, there’s more. In Arizona, even if the operating agreement conflicts with a provision of the Arizona Limited Liability Company Act, the provision of the operating agreement governs, subject to certain restraints.
Among other things, the operating agreement details each member’s percentage of ownership, addresses how the profits and losses will be divided, and outlines each member’s responsibilities.
Now would be a good time for you to read the Arizona statute regarding operating agreements: A.R.S. §29-3015.
After practicing business law and litigation for 30 years, it is clear that many disagreements can be prevented with a carefully drafted operating agreement, one that spells out the relationships of the members. An equally important reason to formalize your operating agreement is to protect the members of the LLC. An operating agreement is often considered “Exhibit A” by the courts with respect limiting the personal liability of the members. Without an operating agreement, a court might assume that the LLC is actually either a partnership or a sole proprietorship.
If you ever need to prove it, a formal operating agreement will lend credibility to your LLC’s separate existence if you ever need to prove it. For example, some banks require an operating agreement before allowing an LLC to open a company bank account.
This next point can’t be said enough. Good operating agreements are detailed! They outline each member’s responsibilities and describe the inner workings of the business. As a general rule, the operating agreement should attempt to leave very few questions unanswered. That way members will know what they should expect during their involvement.
One of the issues that can arise when forming an LLC by oneself or creating it online is that the operating agreement gets forgotten or, if one is created, it is simply too generic. If you buy an operating agreement online, 9 times out of 10 it contains boilerplate provisions that are destined to create problems down the road. Each member should receive a copy of the operating agreement so if questions do arise, one can easily check to see if the answer is already there.
The operating agreement must be signed by every member of the LLC for it to be enforced. Besides, it is much easier to tweak the operating agreement as it is being drafted than once it is finished and being enforced. Amending an operating agreement usually requires the unanimous consent of all of the members. If there is already a disagreement among the members it is unlikely that you will find the votes needed to amend your LLC’s operating agreement.
This may surprise you, but the operating agreement can be oral or sometimes even implied. Consequently, there will almost always be some agreement among the members about their relationship that can be considered to be part of an unwritten operating agreement. But this implies that there will almost certainly be some disagreement as well. This may result in litigation. In the event that the operating agreement is not written, the members will need to prove what their original agreement was and perhaps if and how it was changed. The best practice will always be to formalize the operating agreement in writing and to include as much detail as reasonably possible.
The operating agreement should include decisions about the contributions that the members must provide, such as the amount, form, size, or magnitude, depending on its form. Also, the operating agreement should include terms regarding the expulsion or suspension of members existing members.
Here’s an example of something that is often neglected. What happens to a member’s ownership interest if that member dies? As a valuable property item, the member’s spouse or estate now owns the membership interest in your LLC. He or she may want to step in and become part of the LLC. If that’s agreeable with you, great. Often it is not. You can address this scenario in your operating agreement.
A similar situation might arise if a member of your LLC leaves the company to work in a different state. Or imagine a scenario where a member is unable to make any type of meaningful contribution in operating the company because of an injury or extended illness. If you didn’t think write your operating agreement carefully, maybe these circumstances were never addressed. Perhaps your operating agreement states that each member is entitled to 50% of the profits. This might leave the other member to generate the profits but require them to share those profits with the non-participating member. And, since unanimous consent might be necessary to amend the operating agreement, this might make or break your entire business. You get the point. Try to foresee these scenarios before you finalize your LLC’s operating agreement.
Finally, you should be aware that Arizona’s limited liability act states that “[t]o the extent the operating agreement does not provide for a matter described in [§29-3104], this chapter governs the matter.” This means that if you don’t draft an operating agreement, or if you draft an agreement but don’t address certain issues, the state of Arizona will supply the terms and conditions for you. This may result in a bad outcome.
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Your company’s future depends on its continued growth and financial health. Effective strategic planning is the backbone, but many other factors contribute to keeping your business on an upward trajectory.