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The importance of operating agreements - and why every business needs one

One of the most popular business structures for small to medium sized businesses is the Limited Liability Company (LLC). This business structure is popular for many reasons, chief among them the flexibility the business has to define their own rules regarding operations, and each member's financial and managerial rights and responsibilities.

Every business needs a written agreement laying forth its operation plan, policies and rules. While many businesses have an idea of their goals, responsibilities and policies, having these items laid out in writing will provide a sense of consistency, help the business run more smoothly, and assure that everyone involved understands their personal role, as well as their rights and responsibilities to the business.

What happens to LLCs without operating agreements?

LLCs without operating agreements are governed by New York's limited liability company law. While this law may work for your company, it will also cause you to lose the flexibility many entrepreneurs crave when starting their own businesses.

What you should include in your operating agreement

  • Each member's percentage of interest and ownership. New York law will automatically assign a level of ownership to all members of an LLC if it is not defined, and the rules used to assign ownership won't always make sense for your business.

For example: If an LLC has four members and cost $50,000 to start up, New York law will assign interests based on each member's financial contribution. So, the person who invested $2,000 will not carry as much ownership as the person who put in $20,000.

This doesn't work for every business. Oftentimes, the person bankrolling the business is not the "idea" person or the person with the skills necessary to make the venture a success. Developing your own operating agreement will ensure each member is given the appropriate level of ownership.

  • Each member's responsibilities and rights in the business. Each member of an LLC has their own set of strengths. Declaring these in the operating agreement gives everyone a clear role - one that draws upon their abilities - and ensures all members have clear expectations of their responsibilities and what they can expect from one another.
  • The weight of each member's voting rights. Some companies dictate voting rates directly in proportion to how much of the business they own. Others choose other methods or rationale, such as each member's education or experience level, to decide voting rights.

In New York, unless there is an operating agreement in place, voting rights are determined by the same method as interest of ownership: by percentage of initial contribution.

Operating agreements should also lay forth how decisions will be made in the event of a tie.

  • How profits and losses are distributed. These also can be divided based on the amount of time or money that is put into the business, or members can agree on a different set of criteria that they find fair and logical.

Once again, without an operating agreement, New York law will default profit and loss distribution to each member's contribution.

  • Rules for buying and selling shares of the business. If there are multiple owners in a business, the company may want to have rules regarding each person's ability to sell to one another, and lay forth rules regarding selling an interests or share of the business to an outside individual. This will protect members from losing controlling share of the business and the possibility of unwanted outside members being brought into the organization.
  • Provisions for reorganizing if one of the members dies or becomes unable to continue membership. Many businesses do not plan for an unexpected gap in the membership structure of the LLC. Putting a plan in place will help ensure the continuity of the business.

An operating agreement will only strengthen your business

Operating agreements take the doubt and confusion out of daily business operations and provide guidance when more unique situations arise. Even where there is only one member of the LLC, it is still beneficial to have a formal operating agreement to help reduce the individual's legal responsibilities if a lawsuit arises.

You need an operating agreement even if all members are on the same page

When businesses are being formed, there is a lot of excitement in the air. Members may informally discuss a few aspects of the business, and when they seem to be in agreement about those few things, they begin to assume their ideas are in sync across the board. This isn't always true - and even if it is those ideas can change over time.

Future disagreements about the direction of the business, and the rights and responsibilities of the members can lead to internal squabbles and even damage relationships with clients or employees. Overall, this can cost the business money, and may even prevent future success. Working with an attorney to set up a proper operating agreement will provide your business with a strong foundation upon which to move forward and prosper.

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