What is an operating agreement?

We break down operating agreements and how they can help protect your business. Learn more about the benefits of operating agreements.

signing a business operating agreement
Get a Quote

If you’re creating a new company, the business structure you choose impacts your personal liability, taxes, paperwork, and your ability to raise capital. For example, a limited liability company (LLC) is a less formal business structure that increases personal protection from liability.

But selecting a business structure is not as simple as declaring your company as an LLC; there are legal documents and paperwork that must be filled out and signed by the key members of the company.

This brings us to the operating agreement (OA), which outlines the company’s leadership structure, ownership, rules, regulations, and provisions. Once signed, it binds members to its terms.

Curious why an operating agreement matters and what needs to be included for it to be legitimate? We’ll break it down for you.

What is an operating agreement?

An operating agreement is an official contract, enforced by law, that addresses many of the situations that could happen to the company, and lays out the proper actions to take should those circumstances occur.

For instance:

  • What if a member leaves? What happens to their ownership stake?
  • What if a member doesn’t want to be involved in day-to-day management?
  • What if a member is sued?

Thus, an operating agreement establishes several aspects of the LLC membership, including their:

  • Ownership
  • Duties
  • Obligations
  • Liabilities
  • Rights

Although no state in the country legally requires an LLC to file their operating agreement with the state registrars’ office, certain states dictate that you need to have an operating agreement for your business records.

For example, California states,1 “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; if they are submitted, they will be returned unfiled.”

What does an operating agreement include?

Although operating agreements vary, most will contain six primary articles, including:

  • Article I – Organization – 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, which will be 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 correspondences

It will cover membership in detail, including ownership and how profits, losses, and taxes will be dispersed between members. It will also spell out how new members can be added. 

Article II – Management and voting – Addresses how the company will be managed and how its members can vote on business issues. Members may appoint a single (or multiple) manager(s), and then 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 – Highlights which members have provided capital to help start the LLC. It also covers how new money can be raised by members.

Article IV – Distributions – Details how the business’ profits, losses, and other assets will be dispersed between members.

Article V – Membership changes – Clearly explains how members can be added or removed. It also handles how ownership can be transferred.

Article VI – Dissolution – Lists the reasons or times when the company may or must be dissolved.

Why an operating agreement matters

At its essence, an operating agreement is all about providing clarity. Getting into business with others can be messy, complicated, and lead to internal disagreements. An operating agreement clearly states the rules and provisions so that every member is on the same page. Once it’s signed by the members, it officially binds them to its terms.

So, what are the benefits of an operating agreement?

Sets verbal agreements in stone – In the early stages of a business, many of the plans are based on handshake agreements. Because miscommunication can happen, this can lead to misunderstandings or disagreements (where one side thinks they were promised something and the other side disagrees). When put in writing, the agreements are clearly stipulated and can be referenced if a conflict comes up.

Protects the members from liability – It’s important to note that all operating agreements must include a liability and indemnification clause, which includes legal language stating that members of the company have limited liability for the actions they take 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.

Make your business agreement official in the eyes of the government – Although you’re not legally required to file an OA with the state, having one ensures that your agreement isn’t managed by the state’s default rules—which govern LLCs that lack an OA.

Put simply, it’s a risky decision to run a business without a signed, physical operating agreement. Without it, you are personally exposed to liability and several other potential headaches surrounding ownership and member’s rights. So, work with an experienced attorney to ensure that everything is in place and that you have all of your bases covered.

Business liability coverage

Once your operating agreement is set in stone, the next step you can take to protect both 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.

Thimble offers our customers on-demand policies that go by the hour, day, or month. It’s insurance that’s on when you’re on, and off when you’re not on the clock.

Curious how to get started? You can protect your small business from liability in under 60 seconds. Just download the Thimble app or click “select a quote” to get started.

Like an operating agreement, liability coverage is all about foresight. It’s about anticipating the problems that could crop up and putting structures in place to protect your business.

It’s about being prepared.

 

Sources:

Our editorial content is intended for informational purposes only and is not written by a licensed insurance agent. Terms and conditions for rate and coverage may vary by class of business and state.

Related Articles