The Operating Agreement: Why Every LLC Needs One
An operating agreement is the contract entered into between the members (owners) and managers of a limited liability company that governs their rights, obligations and duties when conducting the business of the LLC. Although Arizona law does not formally require an LLC to have an operating agreement, every LLC needs an operating agreement have one regardless of the number of members.
Operating agreements address many issues, including:
Protecting Assets. Most people form LLCs to protect their personal assets from the debts, obligations and liabilities of the business. However, if the LLC has not carefully kept its affairs separate from the affairs of its members, a creditor may be able to “pierce the corporate veil” and reach the assets of individual members. A written operating agreement is one of the factors that demonstrates the LLC has observed “corporate formalities,” such that the court should respect the shield the LLC provides its members.
Clarifying Verbal Agreements. Even if members orally agreed on terms, misunderstanding happen. With profitable companies, misunderstandings can quickly lead to litigation. The best practice is always to have your agreements in writing so they can be reviewed in the event of any conflict.
Identifying Members & Their Ownership Percentages. While members are typically required to be named in the articles of organization that form the company, their percentage interests aren’t stated anywhere. Shouldn’t that be in writing somewhere? An operating agreement identifies the members and their ownership percentages, and how profits and losses will be distributed.
Decision Making. What decisions can the manager unilaterally make without consent of the members? What decisions must be voted on by the members? How will disputes be settled? These are major questions every business owner should consider before starting a business. An operating agreement will include these provisions in a way that suits the specific needs of the members.
Changing Ownership & Excluding Outsiders. It is critical for members to consider when and if ownership shares may be transferred or sold and to whom. For example, an operating agreement may require a member wishing to sell his shares to first offer them to the other LLC members before they may be sold to anyone else. Also, if shares are transferred, does the new owner automatically become a member with voting and possibly management rights? An operating agreement will state if, how and when a new member may be added.
Company Divorce. Business owners do sometimes decide to part ways. How will this happen? How will ownership shares be valued? Who will pay what to who and how much? What if there is a dispute? When unaddressed, these issues tend to lead to litigation. This can be avoided by creating a comprehensive operating agreement that includes buy-sell provisions.*
Custom Provisions. For example, owners may want a non-compete provision preventing other owners from engaging in outside businesses that directly compete with the LLC. Or, perhaps the members want to identify the specific duties of each member and manager as it relates to the operations of the LLC. These types of agreements should always be in writing.
Avoid Default Rules. Without an operating agreement, by default the LLC will be governed by Arizona’s LLC statutes (A.R.S. §§29-601 to 29-857). Letting the state dictate how the LLC will operate is not want any owner wants for his or her LLC.
