Many small business owners, especially new entrepreneurs, need help understanding the importance of creating a business operating agreement when they first start out. Clarity on the critical issues and procedures is essential, especially for a family business or when going into business with friends.
We assume that because we get along well with our business partners, we can avoid the obstacles that usually sink a business. Unfortunately, this could not be further from the truth. A business operating agreement and articles of organization are like a will—if you don’t have them, you’re setting yourself up for future resentment among your business partners.
What Is a Business Operating Agreement?
What is an operating agreement? A business operating agreement is a legal document that outlines the primary terms and conditions for managing a company. The contract outlines the ownership and operation of the company, its organizational structure, financial details, and other relevant aspects.
What happens if an LLC does not have an operating agreement? If you don’t have a business operating agreement, you might be at the mercy of the state regarding how your business will be managed if a conflict arises. Investors or buyers often require a business operating agreement before showing a genuine interest in your business.
In addition to being required by law for many types of businesses, a business operating agreement protects your assets from liability and documents all management policies and procedures. It also discusses what happens in the event of dissolution.
Every organization, including family businesses, sole proprietorships, LLCs, partnerships, joint ventures, and strategic alliances, needs a business operating agreement. Once you understand the importance of an operating agreement, you should know what to expect when drafting one.
Key Provisions of a Business Operating Agreement
Understanding the key provisions in an entity operating agreement will ensure that your agreement protects all parties and provides clear guidance. It’s essential to understand what a business operating agreement is intended to cover and its purpose.
Membership Interests
Membership interests define who owns what percentage of the company and what rights they have. This section of your business operating agreement should clearly specify each member’s ownership percentage, which typically corresponds to their initial capital contribution.
Transferability provisions are equally important. Most operating agreements restrict the transfer of membership interests to protect the remaining members from gaining unwanted business partners. These restrictions typically include right-of-first-refusal clauses, requiring members to offer their interests to existing members before selling to outsiders.
Buy-sell provisions establish procedures for transferring interests when members retire, become disabled, die, or otherwise want to leave the business, preventing disruption and ensuring smooth transitions.
Management and Control
The management structure determines who has the authority to make decisions and how that authority plays out in practice. In member-managed structures, all members participate in daily operations and decisions.
Manager-managed structures, on the other hand, delegate daily operations to designated managers. The agreement must clearly state which decisions fall within this managerial authority and which require member approval, specifying whether decisions require unanimous consent, a majority vote, or supermajority approval.
Capital Contributions and Distributions
The operating contract should detail each member’s initial contributions as well as any additional contributions. Distribution provisions control the way that profits and losses are allocated among members.
While distributions often correspond to ownership percentages, the agreement can establish different methods of allocation. The agreement should also distinguish between member loans and capital contributions, clarifying the terms of the loan, interest rates, and repayment schedules.
Dispute Resolution
Laying out a process for dealing with disputes will prevent conflicts from destroying the business. The standard business operating agreement should establish an escalating approach, starting with informal discussions, then proceeding to mediation and arbitration.
The agreement should also specify how mediators and arbitrators are selected, how costs are shared, and what the timeframe is for a resolution. Deadlock provisions for situations where members cannot reach a unanimous decision on fundamental matters might include buy-sell mechanisms or appointing a neutral third party to cast a deciding vote.
Liability and Indemnification
Indemnification clauses protect members and managers from any liability that may arise from their service to the company. The agreement should specify that the company will compensate members and managers for claims, damages, and expenses arising from their role, provided that they acted in good faith and in the best interests of the company.
Dissolution
Although no one likes to think of the end, your company’s operating agreement should also establish clear dissolution procedures, specifying what events would trigger dissolution and who will manage the process.
The agreement must establish the priority of distributions, which typically follows this order: outside creditors, member loans and advances, members’ capital contributions, and finally, any remaining assets distributed according to ownership interests.
How Do You Structure an Operating Agreement?
Ultimately, a comprehensive small business operating agreement is in the best interest of all parties involved in a company. Even a sole proprietor can benefit from an operating agreement if their business grows and changes over time.
But what should be in an LLC organizational agreement? An experienced business attorney can explain the importance of each section and help you determine the precise wording. Each business will have slightly different needs. In general, you can expect a business operating agreement to cover the following topics:
- Introduction: The business operating agreement should begin with an introductory segment that explains the purpose and scope of the agreement and identifies all parties involved.
- Formation: Next, include basic information such as the date of formation, the business name, and the terms of the agreement.
- Structure: This section will cover the basics of the company’s creation, including its structure, the identities of its key players, its purpose, and the story of its founding.
- Membership interests: Here, you can include the members and their ownership percentages, as well as other pertinent information about member interests, such as buy-sell provisions, the procedure for admitting new members, and the process for transferring membership interests if desired.
- Member roles and duties: It’s a good idea to talk about each of your company’s key members’ roles, including listing yourself as the owner. Include each person’s duties, contributions, and potential voting rights. You should also discuss how to add or remove members as needed.
- Voting: What is the voting process? What are the requirements around meeting frequency and attendance? How will decisions be made when a consensus cannot be reached?
- Capital contributions: Discuss the initial capital contributions for members and the procedure for additional contributions later.
- Profits and losses: How will profits and losses be allocated among members? How will the finances be distributed? Who will take on any losses you might encounter?
- Distributions: Your business operating agreement should outline the timing and frequency of distributions, as well as the procedures for making special distributions.
- Dissolution: Discuss how assets will be distributed upon dissolution and what events could trigger a dissolution. Regardless of what the future holds, you want to be able to dissolve your business on your own terms.
- Operations management: You can cover your business’s day-to-day operations and management responsibilities here. If necessary, include details like employment agreements and the process for appointing officers.
- Record-keeping: How will data be stored and managed? Who will keep your books? What organizational methods will you use? What is the procedure for financial reporting? Who will have access to your records?
- Disputes: Sometimes, disagreements among members can become contentious. Write up a procedure for resolving these disputes, whether that involves mediation, arbitration, or litigation.
- Amendments: If necessary, how will the business operating agreement be amended? Will unanimous consent or a majority vote be required?
- Miscellaneous: This section would be for anything not previously covered in your business operating agreement.
- Signatures: All members or managers must sign and date the business operating agreement.
How Do I Write a Simple Operating Agreement for an LLC?
Understanding what belongs in a small business operating agreement is only half the battle. Knowing how to create and maintain one ensures that your business remains protected as it grows. Here’s a practical guide for developing and maintaining this critical document.
Step 1: Conduct Initial Consultations
Before drafting begins, schedule discussions with all founding members and stakeholders. These conversations should address each person’s expectations regarding ownership percentages, roles, decision-making authority, and long-term business objectives.
This is also the time to discuss potentially uncomfortable topics like exit strategies, what happens if someone wants out, and how to handle worst-case scenarios. Documenting these early conversations creates a foundation for the formal agreement and often brings to light inevitable disagreements that are far easier to resolve before legal documents are signed.
Step 2: Find Legal and Financial Advisors
While online templates exist, they rarely account for your business’s unique circumstances and the specific requirements of your state. I recommend working with a business attorney who understands your industry and the relevant state laws to draft a contract tailored to your specific needs.
Consider consulting with an accountant or financial advisor as well, as they can provide valuable input on the tax implications of different structures. The upfront investment in professional guidance typically saves substantial money and avoids conflict down the road.
Step 3: Draft and Customize the Agreement
Your attorney will then prepare a first draft of your LLC partnership agreement, incorporating all of the provisions you’ve discussed. Review this draft carefully with all relevant members, paying particular attention to the sections on voting rights, financial distributions, and dispute resolution.
Don’t hesitate to ask questions about legal terminology or request explanations for any clauses you don’t fully understand. This is your opportunity to customize the standard provisions to fit your business’s specific needs and culture.
Step 4: Circulate for Review and Revision
Once the initial draft is complete, give all members plenty of time to review it thoroughly: at least a week for straightforward agreements, but longer for complex ones. Each member should ideally have their own attorney review the document to ensure their interests are protected.
Collect feedback, discuss proposed changes as a group, and work with your attorney to incorporate reasonable revisions. This collaborative review process, while time-consuming, builds consensus and reduces the likelihood of future disputes.
Step 5: Sign and Store the Agreement
After all revisions are complete, schedule a formal signing meeting where all members can execute the agreement together. Ensure everyone receives an original signed copy, and store the original document in a secure location. Many businesses keep copies with their attorney, in a deposit box, and also digitally in encrypted cloud storage.
Keeping Your Agreement Current
A business operating agreement isn’t a “set it and forget it” document. You should schedule annual reviews with key stakeholders to assess whether the agreement still reflects your business’s reality. Consider adding calendar reminders for these yearly check-ins.
Major events, such as admitting new members, significant business growth, changes in state law, shifts in member roles, or approaching member retirement, should trigger immediate reviews.
When amendments are necessary, follow the amendment procedures outlined in your original agreement. Most will require member approval through voting, and all amendments should be documented in writing, signed, and stored with the original agreement. This creates a clear paper trail of your business’s evolution and the members’ consent to changes.
By approaching your business operating agreement as a living document that evolves with your business, you can be confident that it continues to provide the protection and guidance your company needs at every stage of its development.
Regardless of your business’s size, crafting an airtight business operating agreement is the best way to protect yourself, your members, and your organization’s future. Covering all your bases upfront will save you the headache of figuring out your next steps in the heat of a future crisis.
If you still have questions about your business operating agreement, a business coach can help you understand the importance of an operating agreement for your company. Please fill out my contact form to schedule a complimentary video call and discuss how to get started. You can also click here to subscribe to my free weekly blog articles about entrepreneurship.
Coach Dave
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