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.

Even Single Member LLCs Need an Operating Agreement

Single member LLCs need an operating agreement just as much as multi member LLCs. Issues specific to single member LLCs include:

Separation of the Business. An operating agreement proves that an owner has been conscientious about organizing the business as a legitimate enterprise separate from him or herself. By doing do, it helps ensure that the courts will respect the liability protection the LLC provides the member. Note that husband and wife LLCs are usually considered “single member” LLCs.

Clarifying Succession. An operating agreement allows for flexibility in long-term planning – a sole member should specify in an operating agreement what should happen in the event of the owner’s incapacity or death. Without such a written agreement, the LLC may be forced to dissolve after the sole member’s death or disability.

Non-Member Investors. If the LLC has investors that are non-members, the member will want to clearly define in an operating agreement what the individual roles will be, who will make decisions on how the business is run, and how profits and losses will be distributed.

“Sweat Equity.” An operating agreement is also essential for owners who wish to reward employees with ownership in the business. An operating agreement will give the owner discretion regarding employees’ compensation.

A well drafted operating agreement tells the world that the LLC operates separately from its owners, deters costly disputes and litigation, clarifies agreements, and provides the owners with a roadmap of how to run the company. No LLC should operate without one.

At the Neal Law Firm, we  have extensive experience forming companies and documenting their transactions. Contact us for further information about forming and operating your Arizona limited liability company.

We offer a comprehensive, flat-fee LLC formation packages which includes a custom operating agreement for your new business and all filing and publication fees. We also prepare custom operating agreements for existing businesses. Call us today at (480) 699-7992.

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