Go ahead and google “Operating Agreement Disputes” under the news search function. Go ahead – I’ll wait.

Depending on when you read this article, you may see a news story about a $65 million dollar hotel renovation in Palm Beach that is currently on hold as partners sue each other over a breach in the operating agreement. Perhaps you read about Walker’s Restaurant and it’s former LLC manager being sued for a breach of fiduciary duties as listed in the LLC’s operating agreement. Or, you may have read many of the countless partner and member disputes that occur every day that rely on the LLC’s operating agreement for clarity.

If the Articles of Formation is the birth of an LLC, then the operating agreement is the brain (and you’re the heart!). But unlike the Articles of Formation, which is generally a short form you have to fill out for the state, the operating agreement can be significantly more complex, less understood for most new business owners and not as straightforward. The operating agreement can address an almost infinite number of issues pertaining to the operation of your new business and can lay out how to handle the evolution of your business (the only consistent thing in this world is that things will change!).

Because of the potential for complexity in an operating agreement (and I to want to emphasize “potential” – because it doesn’t have to be complex, but it can), we’ve reached out to dozens of experts on the topic, including highly successful entrepreneurs, investors and many business attorneys. We’ll be including their thoughts and comments throughout to help expand on the topic.

What is an Operating Agreement Anyways?

No state requires you to file an operating agreement with the Secretary of State, many just require that you have one on record. Moreover, there are three states – Maine,  New York and Missouri – that actually require you to create an LLC operating agreement and 2 states – California and Delaware – that mention that, even if you don’t have a written operating agreement, they will look for an oral agreement or “implied” agreement; wether or not you explicitly executed one!

Despite this lack of state oversight, an operating agreement is the lifeline of your business. It not only establishes the structure of your business, but it also protects you from liability and, most importantly, it creates the governing rules of your business. That includes detailing how you’re going to account for and handle difficult situations in the future.

Kevin O’Connor, Partner on the Commercial Litigation team at Peckar & Abramson has over 20 years of experience working with corporate disputes. Kevin says “ Business people are often starry eyed about their future prospects together and are simply not able to have foresight about the many difficulties that can arise a few years or even a decade or more into the future.” An operating agreement is meant to help plan for those difficulties.

Generally speaking I think its always in the interests of the business owners to have their agreement prepared by qualified counsel. As a litigation attorney, I can tell you that one common element of a dispute is that the agreement was not fully vetted by legal counsel but instead pulled together by business people or, worse yet, there was no agreement at all. Business people are often starry eyed about their future prospects together and are simply not able to have foresight about the many difficulties that can arise a few years or even a decade or more into the future. There is a misconception that drafting an operating agreement is an expensive proposition. It does not need to be. You just need to shop for the right attorney who is willing to do it on a flat fee. Often these agreements can be drafted in a few hours’ time, assuming no heavy negotiating over the terms.

An operating agreement is a special business “contract” that defines the operations and procedures of a limited liability company (LLC). Business Attorney Mia Mota with the Tech Law firm describes it as being almost equivalent to having a company’s bylaws and shareholders’ agreement in one document.

In an operating agreement, you should try to think through possible contingencies to ensure they are accounted for and included in order to protect the owners and the company in certain situations. That sounds ominous and daunting – where do you even start, what are the factors every business should consider, and what are the factors that you should consider for your business specifically? Remember, an operating agreement is built around your business – and depending on what you plan on doing with your business, there may be specific items for you to consider.

[We] recommend that small businesses hire experienced legal counsel to assist in drafting a LLC’s operating agreement. An operating agreement is basically an internal guidebook on the rules and management of a LLC. Your company’s operating agreement should be specifically tailored to your company, your manager/owners, and to your business’s needs. Obtaining legal counsel for drafting your operating agreement ensures that specific clauses and legal phrases are included, such as:
Who get’s to determine when there are profits to distribute?
How profits – or, often more importantly, loses – allocated?
If someone wants to be bought out and leave the company, how do you decide how much their interest is worth?
What happens in the event there’s a dispute between owners or the company and an owner?
What if an owner dies, what happens to their membership interest?

Operating Agreement Overview

Let’s start with an overview of the items in a standard operating agreement, then dig a little deeper into specifics.

An operating agreement should include the following:

  • Major Terms – Think of this as setting the baseline for your agreement. Major Terms are the major contractual obligations within a contract. They may be more or less enforceable based on the actual law, but this is the core
  • The Name of the LLC – Straightforward – what is the name of your LLC as registered
  • The Term of the LLC – Does your LLC have a specific end date or trigger to end – is it limited in how long it will operate before you wind down? The majority of LLCs are perpetual (i.e. they go on forever), but you can force closure for any number of reasons
  • The Formation Date of the LLC – Straightforward
  • The Purpose of the LLC – Do you know what you’re going to be doing with this LLC? It’s possible to have a general purpose LLC (e.g. something like “The LLC is formed for the purpose of engaging in the business of *. The LLC has the power to do all things necessary, incident, or in furtherance of that business.”) – or it can be more specific if you know what the company will be doing
  • Contributions of Members – Are you starting this LLC with one or more partners? What is each partner contributing to the LLC. Are partners putting in money? Are they experts in a field and will be providing some sort of IP (intellectual property)
  • Liability of Members – Does the LLC agree the members should not be held liable to the company when acting as a Member? What about due to negligence or malice?
  • Management – Who within the LLC manages what? In what cases do you need unanimous approval? Who gets final say in a dispute?
  • New Members and Transferring Shares – Can a new member be added? What happens if a member dies or gets incapacitated – who gets their shares and how are they paid for?
  • Fiduciary Duties – What are the duties of the members to the Company and other members? Are there any scenarios where conflict of interest may arise, or is it ok for a member to act in their self interest (or under what circumstances is it ok?)
  • Meetings – How often do you plan on meeting and what’s to be discussed there
  • Dissolution and Termination – What happens if the company needs to shut down? What happens if a member owes the company money? Can a member ever be removed? If so, how?
  • Miscellaneous By-Laws – a catch all for * a lot* of other potential issues that may come up

Once an operating agreement is drafted and agreed upon by the LLC’s members, the operating agreement becomes the heartbeat of the LLC – every decision will somehow be rooted in the operating agreement.

At this point – you might be asking yourself, do I need an operating agreement if I’m a single-member LLC. Isn’t it redundant to have one? You’re basically writing up a contract with… yourself. Attorney and CPA Michael Margrave absolutely recommends that you do –

If the operating agreement is for a single-member LLC, we recommend some form of operating agreement be utilized, be that our basic form or a form that the member procures. If the member wants us to review a form not prepared by us, we will advise that we can do that although it may be more cost effective for our form to be utilized. In this scenario, the operating agreement is often more important to provide evidence downstream if liability issues arise that the entity has been operated as a separate business and is clearly distinguishable from the activities of the member/owner.

To parse that down, one of the big reasons you are opening up an LLC is to protect yourself as an individual from debts and liabilities that the business may incur – i.e. if the business takes on a bank loan and ends up failing, the bank can’t come after your personally to collect on the loan (assuming you didn’t personally guarantee the loan). However, the courts are not dumb, if you use the limited liability company in a way that it co-mingles with your personal accounts, or the LLC is clearly a sham – it’s possible that some or all of the debts and liabilities can be assigned to the individual member(s), something knowns as “piercing the corporate veil”

courthouse

So – how does having an operating agreement help you?  If someone is trying to make a claim against you personally (to pierce the corporate veil) – you will have to show that the business entity is in fact separate from you as an individual. The operating agreement can act as a proof point.

How to Get Started

It’s clear that an operating agreement should be part of your plan when starting a new company via LLC. The next question is generally… what do I do now? How do I start writing the operating agreement and do I need an attorney to help me or should I do it myself?

After talking to dozens of experts, successful business people, attorneys specializing in business law and others closely tied to the start-ups and company creation, we got an answer…

So, without further ado – THE DEFINITIVE answer is… It Depends.

Sorry for the build up and the let down, but, like most things in business, the right answer is not always straightforward and there is too much nuance to be able to say that there is a right approach for every case.

With that in mind, let’s explore the different options and hear from the experts so that you can make the decision that is best for your business.

There are 2 main approaches to creating an operating agreement:

  • Do It Yourself: Generally finding a form operating agreement online and working to modify it to suit your needs
  • Working with an attorney: Finding a qualified attorney to help you draft an operating agreement that suits your needs

There is a huge spectrum across these two options and even within the two approaches, so we’ll try to explore each option in depth using thoughts and advice from qualified individuals we talked to

crossroads
The first fork in the road when you start your LLC – DIY or work with an attorney?

Option 1: DIY – or “I’m going to avoid an attorney and write something up myself”

As of writing, only 5 states in the US require that you have an operating agreement: California, Delaware, Maine, Missouri and New York. That being said, no state requires that you file your operating agreement with the state, just that you have one that’s been adopted internally as a business. Many business owners forgo drafting an operating agreement; but as we’re learning today – that’s certainly not a good idea. One measure that some business owners take is to draft their own operating agreement – either as a final document or as a document to take to an attorney. Generally this starts by finding a form agreement and either modifying for your business or filling in the blanks.

Using a Form Operating Agreement – the Risks and the Rewards

There are many examples of form operating agreements out there, but the basic idea is the same: A template with “fill in the blank” spaces to put in your specific company info. In some cases, these templates can be a little more customized based on the specific industry that you work on, but the customization is generally limited. There are a handful of companies that provide these services, like IncFile and LegalZoom, but the enterprising LLC owner can do a little bit of extra googling to find a free template to use.

At the end, you can print, save and sign your document. It’s as simple as that.

In many cases, this satisfies the *technical* legal requirement associated with the states that required an operating agreement, but it may also fall short of what you really need to protect your business and yourself from misfortune. Let’s review the benefits and risks of using a form/template operating agreement.

When I open a company “I pretty quickly set up an LLC, and I have a form operating agreement that I’m pretty comfortable with that I use.”

— Afif Ghannoum, CEO BIOHM Health and Forbes Contributor

Form Operating Agreement – Benefits

There are several benefits to using a form/template operating agreement

  • Cost: It is going to be less expensive than working with an attorney. The costs can range from Free to $150 for a company like LegalZoom to walk you through the template.
  • Speed: A form/template agreement can be filled out quickly – in under 30 minutes if all you’re doing is reading through the document and filling in the blanks.
  • Satisfies Technical Legal Requirement: The 5 states mentioned above that legally require an operating agreement have very light guidance on what is actually required in the agreement – most forms you can find online or pay for should satisfy the requirements.

As Afif Ghannoum, CEO of BIOHM Health and Forbes contributor tells us: “[When I open a company] I pretty quickly set up an LLC and I have a form operating agreement that I’m pretty comfortable with that I use.”  As an experienced business person, Afif is optimizing for speed for his LLCs so that he can quickly get the LLC off the ground.

Form Operating Agreement – Risks

There are several significant risks associated with using a form/template operating agreement.

  • Not Thorough: Depending on your specific business, the numbers of partners that you have and how you want to operate, it’s likely that a form template will not cover all of the cases or scenarios that might pop up.
  • Not Tailored: Different business types have different operational requirements, as does where you’re operating and how you’re conducting business. A form agreement may include items that are not relevant for your business and will confuse things. The language used may also be interpreted differently based on where you’re located and previous case law – that may not be accounted for in the form.
  • Lack of Understanding: Have you read through the operating agreement template? Do you fully understand what is being said and what agreements you’re adopting? Even if the answer is yes, do you now know how the agreements and language you’ve adopted in your operating agreement will be acted upon by the courts in a legal case (i.e. what precedents have been set and how your local courts react to certain cases)? The first rule of any contract is to make sure you understand what you’re signing; that’s the case here as well.

You may be asking yourself – what if I use a form operating agreement and ask an attorney to review it to make sure I did it right and everything looks good. We asked this to our panel of attorneys and the overall consensus was that it doesn’t really work that way. Michael Smith, Named Partner at Smith Rayl Law Office, LLC puts it well when he said:

A similar question I sometimes get from clients is something like, “I’ve already written the operating agreement. Will you just give it a quick review?” I’ve tried that before, and it doesn’t work very well. I have the same professional responsibility obligations if I “just give it a quick review” that I have if I write it entirely myself, and I will not do the work without doing a thorough review and, if necessary, an extensive revision. Moreover, it’s not likely to save the client any money because it often takes longer to review and revise another person’s document than it takes to write one using language that I’ve already developed and refined myself. In addition, some clients are offended to receive a marked-up document that looks as if it’s been bled all over. If the client has already written something, I may take a look at it for input, but I will still plan to start all over myself.

 Essentially what every attorney agrees on is that, if they are going to sign-off on a document as being “good to go”, they have a professional responsibility to really understand the document and make sure it fits the client’s expectations. As such, they almost always end up re-writing the document and the cost savings the client expects are not there.

Data Inspection

One thing to keep in mind – an operating agreement does not necessarily need to be a static document. In the end, a legal agreement is only as good as how well it works to serve you so you should review annually and make adjustments as necessary. Steve Shindler, CEO and Co-Founder of AngelRoot, a resource for startups to network and empower each other, believes that using a form operating agreement and making adjustments as the business grows is just fine. As someone who founded and sold 3 companies and took a company public, he sees no issue with form operating agreements. As your business grows and expands, you always have the ability to amend your operating agreement and tailor it to the vision and purpose of your company. The caveat here being that Steve, like Afif mentioned previously, is an experienced business owner and has been through and seen a lot so he may be able to head off problems before they sink a company. Both Afif and Steve use form operating agreements as an initial framework to get their LLCs kicked off quickly, but, in both cases, once they start working on the business in earnest and better understand what the business is and what challenges they may face, they, along with their attorney, tailor their operating agreements to suit the purpose of the business better.

“I also think an LLC operating agreement is something that the members should revisit at least on an annual basis. Circumstances sometimes change and companies pivot and what made sense a year ago might not make sense today. It is good practice for LLCs to hold an annual meeting, and that’s a great time to look over the operating agreement with the LLC’s attorney to see whether some revisions might be needed.”

Option 2: Lawyer Up

While those who have started businesses before don’t mind using form operating agreements, it may be beneficial that new entrepreneurs hire a business attorney. New business owners don’t have the experience of starting multiple businesses and falling back on their intimate knowledge of the business world.

Starting an LLC with another founder is like a quasi-marriage and the operating agreement will establish resolutions for problems that might come up. For example – if there is a dispute among members, you will have established guidelines for how the company is going to be valued and what the exit will look like.
It’s potentially dangerous to start an LLC with another founder without having an operating agreement, but almost anything is better than a form. The operating agreement for an LLC is like the bylaws and shareholder agreement for a C-corp, but all in one; it’s complicated and detailed, so you have to make sure to get it right.

For this very reason, the vast majority of business lawyers recommend that LLC founders have a lawyer prepare an operating agreement. A LLC operating agreement is one of the most complex and in-depth documents that your LLC will be held responsible for, and, according to Dana Shultz, an attorney who specializes in Business and Start-Up Law in the San Francisco Bay Area, many founders “don’t know what should or should not be in the agreement.” Even if a client bring him an existing operating agreement for review, it is often “more efficient for me [Dana] to start over, taking the client’s specific needs into account than to fix the existing OA.

I consider it significantly better for LLC founders to have a lawyer prepare an operating agreement (OA) than for the founders to prepare one on their own:

They don’t know what should or should not be in the agreement.
If they use someone else’s form of agreement, they won’t know which provisions are well-drafted and which are not.
If someone does bring an existing OA to me, it invariably is more efficient for me to start over, taking the client’s specific needs into account, than to fix the existing OA.
In the course of working with the client, I make sure that the OA and other formation-related documents comply with the founders’ expectations. (For example, you would be amazed how frequently founders mess up whether the LLC will be member-managed or manager-managed.)

Nevertheless, I understand that many LLCs are on a tight budget and that legal services may not be the highest priority. So, when I work with an LLC (or a corporation) that has been in existence for a while, the first task, invariably, is what I call “clean-up”: Filling in any pieces that are missing, and fixing any problems, so then we are in a proper position to move the entity forward from a legal perspective.

Having a lawyer draft your operating agreement will also help save you headaches down the road. If you formed your LLC with multiple members, you will more than likely have some sort of disagreement about a financial decision or the direction of your business. A strong operating agreement, one prepared by an experienced business lawyer, can save both you and your business. Kevin Brick, a business lawyer for Brick Business Law who regularly advises LLCs and business owners on a variety of legal issues, cautions that:

“Business owners often visit an attorney once they realize they have a problem, but not before. The adage that an ounce of prevention is worth a pound of cure applies to business planning as much as anything else. In the early stages of a business, business owners may make initial representations, agreements or other promises to each other. After a disagreement arises amongst business owners in an LLC, the past agreements, words and actions – all of which may have consequence – cannot be undone. If a dispute later arises, and the Operating Agreement is not properly agreed upon, drafted, adopted and memorialized, the parties can find themselves in a difficult position with the business held hostage. Sometimes a worse situation arises if the parties have drafted their own documents without the help of an attorney, which can have unintended legal consequences.

The process of consulting with an attorney to draft an operating agreement forces the parties to consider and agree upon important issues in the early stages of an LLC. What happens if a member dies? Under what conditions can a member transfer their shares? What are each person’s responsibility? What matters will require unanimous decisions and which ones would require a majority vote? Making these determinations early on, and properly documenting them in an Operating Agreement, can go a long way in avoiding significant stress, expenses and difficulties as the LLC moves forward.”

With that, let’s go into the benefits of hiring experienced lawyers to help you draft an operating agreement.

Lawyer Written Operating Agreement – Benefits

  • Thorough: A good lawyer will be detail oriented and thorough when drafting your operating agreement. They will take the time to understand your business and ask you the difficult questions up front. They will make sure you’re turning every stone to cover as many bad case scenarios as is prudent ensure an upfront understanding of the process and specifics used to solve these issues.
  • Foresight: A good lawyer will be able to talk from their experience on the challenges and issues that they’ve seen come up from their legal experience working with similar companies. This will allow you to head off common situations and circumstances that may impact your business that you might not know exist.
  • Customized: Having an operating agreement customized for your business is helpful. It can help you make sure that the right terms and agreement are put in place for your business and no extraneous items that may confuse the agreement are left in.

An airtight Operating Agreement, one that is fully customized and tailored to your particular business and situation, can ensure the longevity and health of your business.

I recommend LLC owners hire an attorney who will work with them through the initial document process. Since an operating agreement protects the LLC’s members during an audit as well as during litigation why not leave those tasks to the experts? An entrepreneur should focus on filling a societal need. Additionally, a well written operating agreement will account for growth and evolution of a business.

Lawyer Written Operating Agreement – Risks

  • Cost: There’s no way around it. An operating agreement prepared by a lawyer will cost more than an operating agreement prepared using a template.

That being said, in many cases, you should think very carefully about the state of your business if you think you won’t be able to afford a lawyer to help draft your operating agreement. Chris Clark offers the point that “If an LLC can’t afford to hire an attorney to help with an operating agreement and other basic legal necessities, the company is likely underfunded.”

I know that lots of new business owners are strapped for cash, but it is usually money well spent for several different reasons. For example, a lawyer can help with some basic decisions that can affect the economics of the business from the very beginning, such as working through the decision of taxation as a partnership or under Subchapter S (or, theoretically, Subchapter C, although that is seldom the best choice). In addition, the lawyer will ask questions that will force the business owners to think about unpleasant possibilities, such as what happens upon the death of one of the business owners or when the owners disagree, and those things can happen even from the very beginning. A more technical reason for LLCs that are taxed as partnerships is that some provisions, in order to be effective under the Treasury Regulations, must be in the operating agreement from Day One.

Conclusion

There are several ways that you can go about creating your LLC’s operating agreement. You can create one yourself using the multitude of incorporation services out there or you can hire an experienced business lawyer to draft a custom agreement for you. In the end, you need to decide what the best option is for you based on your budget, how much time you have and your risk tolerance. Remembering that an LLC operating agreement need not be a static agreement is important. Revisiting the agreement regularly can encourage you to make the necessary changes and modifications to evolve the written document as your business grows and evolves. At some point, an attorney will need to get involved, and working with a lawyer up front can help you think through and side step potentially large issues down the road – but the reality is that a lot of small businesses start off on a barebones budget. Whichever way you go, remember – work to understand the impact of your operating agreement and don’t be afraid to make modifications and changes as necessary to better support your business. 

Special thanks to:

Paul Miller, Dana Shultz, B. Mia Mota, Michael Margrave, Chris Clark, Mollie Schwam, Kevin O’Connor, Steve Shindler, Michael Ray Smith, Kevin Brick, Afif Ghannoum, Paul Chander

Without your help and the conversations we had, this article would not be anywhere near as complete, accurate or helpful.

Leave a Reply