It’s critical to protect your small business with legally binding documents. One key contract, the operating agreement (OA), outlines leadership structure, ownership, rules, regulations and provisions — and once signed, it binds the signing members to its terms.
Let’s break down how an operating agreement — well, operates — why it matters for your small business and what you need to include for it to be legitimate.
What is an operating agreement?
An operating agreement is an official, legally-enforced contract that addresses many situations that could happen to your small business. It also lays out the proper actions to take should those circumstances occur.
- What if a partner leaves the business? What happens to their ownership stake?
- What if an owner doesn’t want to be involved in day-to-day management? Who is responsible for management decisions?
- What if someone sues a managing partner or officer of the company? Will the company pay their defense expenses?
An operating agreement is a binding document governing a company’s internal operations. Let’s say that you and a colleague confirm a decision verbally but not in writing, and now it’s in question and causing internal chaos in the company. A well-drafted operating agreement clearly states the company’s rules and regulations to help settle such misunderstandings and disagreements, so there’s no disruption to your operations.
LLCs and operating agreements
When founding a company, the business structure impacts your liability, taxes, paperwork and ability to raise capital. A limited liability company (LLC) is a less formal business structure that limits personal liability, effectively creating a barrier between your business and your personal finances.
Selecting a business structure is not as simple as declaring your company as an LLC. An LLC operating agreement establishes several aspects of the LLC membership, including:
If you choose to operate as an LLC, an operating agreement clarifies critical financial decisions and regulations for your small business members. Once it’s signed, the official contract legally binds all parties to the terms and conditions set forth.
The U.S. Small Business Administration notes, “It is unwise to operate without an operating agreement.”1 Furthermore, you’ll need to create an LLC operating agreement when incorporating in the following states:
- New York
While no state legally requires an LLC to file its operating agreement with the state registrars’ office, certain states dictate that you must keep an operating agreement with your business records. You can check the Secretary of State’s website to confirm the applicable guidelines based on where you form your LLC.
For example, as California states, “Operating Agreements are to be maintained by the limited liability company and are not filed with the California Secretary of State. Please do not submit Operating Agreements for filing.” Basically, if they’re submitted for filing, they will be returned unfiled.2
How do operating agreements work?
Establishing an operating agreement should be one of your first steps when starting a small business. An operating agreement allows for more clarity and limited liability in business operations in any state.
Typically, LLC operating agreements are between 10 to 20 pages long. You can start to build one with an LLC operating agreement template containing boilerplate language shared across LLCs. Since an operating agreement defines its members’ unique rules and regulations, you’ll need to customize it for your small business.
If you don’t create an operating agreement, your small business will be privy to state jurisdiction. State-by-state guidelines will likely be much more general than the nuances that govern your company; this can lead to increased liability or the mishandling of sensitive matters, like members’ ownership stakes or profit claims.
Conducting business without an operating agreement can hurt your small business in the short and long term. Now let’s get into the nitty-gritty details.
What does an operating agreement include?
Although operating agreements vary, most will contain six primary articles, including
Article I – Organization
Article 1 covers the creation of the business. It addresses the whos, whats, whens, whys and wheres. This will cover:
- The LLC’s name
- Details about the Articles of Organization, filed with the state registrar
- Address of the LLC’s principal office
- Duration of the LLC, which will either be until a specific date or “until dissolved”
- Stated purpose of the business
- Name and address of the registered agent (who will be receiving legal notices and correspondence)
It will cover membership in detail, including ownership and how to disperse profits, losses and taxes between members. It will also spell out how to add new partners or officers.
Article II – Management and voting
Article II addresses how you will manage the company and how its members can vote on business issues. Members may appoint a single (or multiple) manager(s), and the OA establishes their authority.
Another option is to have all company decisions made by a voting process. In this case, the OA would stipulate how the voting process works, how much a person’s vote counts, or how many votes are required for an action to take place.
Article III – Capital contributions
The third article highlights which members have provided capital to help start the LLC. It also covers how members can raise new money.
Article IV – Distribution
Details how the company will disperse the small business’ profits, losses and other assets between members.
Article V – Membership changes
Clearly explains how to add or remove members. It also handles how to transfer ownership.
Article VI – Dissolution
Finally, this article lists the reasons or times when you may or must dissolve the company.
Why an operating agreement matters
An operating agreement provides clarity. Getting into business with others can be messy, complicated and lead to disagreements. An operating agreement clearly states the rules and provisions so that every member is on the same page. Once the members sign it, it officially binds them to its terms.
What are the benefits of an operating agreement?
- Sets verbal agreements in stone – In the early stages of a business, handshake agreements form many plans. Because miscommunication can happen, this can lead to misunderstandings or disagreements. When put in writing, the agreements are stipulated and referenced if a conflict arises.
- Protects the members from liability – It’s important to note that all operating agreements must include a liability and indemnification clause, which contains legal language stating that company members have limited liability for their actions on behalf of the company.
Without the specific formality of an operating agreement, members might not have coverage since the LLC could be viewed as a partnership or sole proprietorship.
Are operating agreements required?
Although you’re not legally required to create an OA unless your business is formed in the states of California, Delaware, Maine, Missouri or New York, having one ensures state jurisdiction won’t decide your small business operations by default. These general rules often won’t apply to the specific situations your company will encounter, like profit-sharing and ownership.
Other instances where you may need an OA include:
- If you intend to open a bank account and seek a loan or other investment in your company’s name, financial institutions may also require an OA.
- Additionally, the IRS may request to see your OA as proof of your ownership interest in the business.
If you’re the sole member of your LLC, it’s still a good idea to create an operating agreement. By outlining that your business is a distinct entity, your OA gives you limited liability, which protects your personal assets in case of any company legal issues.
It’s risky to run a business without a signed, physical operating agreement. You may find yourself personally exposed to liability and other potential headaches surrounding ownership and members’ rights without it. Work with an experienced attorney to ensure that everything is in place and that you have all of your bases covered.
Now that we’ve covered operating agreements, are you still a little confused about the difference between an LLC and a partnership? We’ll explain further.
What’s an LLC agreement vs. a partnership?
While an LLC is a partnership, a partnership is not an LLC. An LLC mixes aspects of corporations and partnerships with clearly defined rules and regulations for multiple parties going into business together. A partnership brings together two or more business partners, but there isn’t paperwork like an operating agreement.
An LLC provides you with greater financial protection by creating a distinct separation between the company and your personal assets, while a partnership puts the business at risk for liability. Without a formal business separation, your personal assets won’t be protected. Make sure to get your operating agreement set up before you open the doors to your business!
Business liability coverage
Once you set your operating agreement, the next step you can take to protect yourself and your business is to purchase the right insurance. So, if you need general liability insurance or professional liability insurance, you’re in the right place.
Like an operating agreement, liability coverage is all about foresight. It’s about anticipating potential problems and putting structures in place to protect your business. It’s about being prepared.
Thimble offers policies by the job, month or year. It’s insurance that’s on when you’re on and off when you’re not on the clock. To get started, click “Get a Quote” or download the mobile app, then answer a few brief questions. You can get coverage in less time than it takes to sign your name.