Why your limited liability company needs an operating agreement.
Originally published: 08.01.07 by Mike Coyne
The limitedliability company has become one of the most popular ways of doing business.Owners of a limited liability company enjoy the same protection from personalliability for business obligations as shareholders in a corporation. However, alimited liability company has the advantage of fewer required legal formalitiesand more flexibility. For example, in most states, corporations are required tohave stock certificates, bylaws or regulations, annual meetings, boards ofdirectors, and officers. In many states, none of these requirements exist forlimited liability companies.
While somestates require limited liability companies to have a written document called an"operating agreement," many states only require that the owners file verysimple organizational documents with the state. Whether or not your staterequires an operating agreement, you should consider having one.
An operatingagreement is simply an agreement among the owners (usually called the"members") that documents how the business will be run. It usually describeswho is in charge, how decisions will be made, how profits will be shared, howdisputes will be settled, and how a member can get out of the business.
The agreementcan restrict the member's ability to transfer his share in the business and canprotect the business from having to accept someone as a member, even if thatperson buys the interest of an existing member.
There are afew situations where an operating agreement is absolutely critical. Forexample, many growing businesses will look to raise money from outsideinvestors who are not going to be involved in the day-to-day operation of thebusiness. The business owner will want to have a clear understanding with theinvestors as to what their role will be. Typically, the business owners willnot want the investors to be involved in decision-making. The investors, on theother hand, will want some assurances that their investment is going to beprotected. They will also want an agreement regarding how their share ofprofits will be determined and how profits will be distributed. These are thesorts of things that are typically included in the operating agreement.
If you aregoing to be borrowing money from a bank, the bank might look favorably on theexistence of an operating agreement that reflects a good business structure andspecific rules regarding how the business will be run.
If you planon rewarding employees by providing them with a small ownership interest in thebusiness, an operating agreement is absolutely essentiall. Most state lawsprovide special protection to minority owners and hold the majority owners to aspecial standard of conduct with respect to those minority owners. As a result,there are numerous court cases where minority owners have successfullychallenged the compensation, benefits or perks paid to the majority owners. Toavoid these types of problems, an operating agreement can provide the majorityowners with absolute discretion regarding compensation matters. Alternatively,the operating agreement can provide minority owners with a limited right toprofits that is not affected by the profits paid to majority owners.Additionally, the operating agreement can provide that the minority owners donot have a vote in business matters or only have a vote in limitedcircumstances.
Evenfamily-owned businesses can benefit from an operating agreement. Many operatingagreements provide that if a member enters into bankruptcy or is subject to adivorce action, then the member must sell his interest back to the business fora predetermined price. Frequently, the price in these circumstances is lowerthan it might be otherwise. This has several advantages. It protects thebusiness from having to open up its records to the courts and outside parties.It eliminates controversy regarding the value of the member's interest sincethe value of the interest is written right into the agreement. It also is agood way of keeping creditors and ex-spouses out of the business.
If you arethe sole owner of the limited liability company, an operating agreement is lessimportant. However, you could use a simple operating agreement to give someonethe authority to make business decisions in the event of your incapacity ordeath. Without a written agreement of this type, the representative of yourestate may have to go to probate court to get permission to operate thebusiness.
A goodoperating agreement can be a useful tool for running your business. If youthink you might benefit from such an agreement, contact your legal advisor forhelp.
MichaelP. Coyne is a founding partner of the law firm, Waldheger Coyne, located inCleveland, Ohio.Mike's practice focuses on business and tax planning for closely-heldbusinesses and professional practices, as well providing legal counsel onqualified retirement planning, mergers and restructuring. For more informationon the firm, visit www.healthlaw.com,or call 440-835-0600.
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