Operating Agreements: What You Need to Know

Don’t know what to expect when reviewing an operating agreement or why you need one? If so, this knowledge article is perfect for you! 

An operating agreement details how things will be conducted within your business (LLC). You can think of it as your guide to your company’s corporate governance. This is an exciting next step! Your company is transitioning from a concept in your head to a full-fledged business.

With any new venture comes new responsibilities. One of the most foundational elements of starting your own business is having an operating agreement that spells out how you, the Founder, will build your business to last. Every LLC company needs an operating agreement to testify that you are serious about operating your business, to defend against lawsuits, and to separate your personal assets from your LLC’s debts or legal judgments. In this article, we will discuss what an operating agreement is and why it is important for your company.

What is an Operating Agreement?

An LLC operating agreement is a legal document that spells out your company’s rules, regulations, and processes. Topics within the agreement cover:

1. Executive Relations: Spells out the standards of the relationship among all business partners
2. Profit Sharing: Expresses the ratio you will use to distribute profits amongst stakeholders
3. Ownership Percentages: Usually determined by how much capital contribution each owner has contributed to your company
4. Owner Classifications: Your business classification should be a Limited Liability Corporation (LLC)
5. Voting: The rules on how the voting process for your company will be conducted

By having these topics in writing for all members to refer to, your operating agreement sets clear expectations for the business and brings clarity to the operations and management.

Fast forward a few years from now. It is no longer just you running your company. You have a board. You have a team of fifty people relying on you for their salaries and nationwide product distribution. While an operating agreement may not have seemed important in the early days when it was just you, it now allows you to leverage your board for strategic support, make decisions on distributing (or not) profits, and determining dispute resolution within your LLC.  

Why are Operating Agreements Used?

An operating agreement specifies the rules of your business to protect the interests of your company and stakeholders from bad actors. One of the unique components of an LLC’s operating agreement is its ability to supersede the general cookie-cutter state laws that govern LLCs. Operating agreements establish corporate governance for your business. Without an operating agreement, ownership of the business is handled according to the jurisdiction in which your LLC was formed. Now, your operating agreement serves as a protection and a structure against rogue actors.

When starting your business, it can be easy to push aside forming an operating agreement. After all, you are probably already drowning in a sea of paperwork, juggling a million different tasks, you may have established personal history with your fellow members, or perhaps even have some business experience together. However, you must make time to establish an operating agreement.

At this point, you are probably one of the only members of your business. Because of this, your consumers probably know you and associate you with your company. As you begin to grow and scale your business, consumers will instead begin to recognize your brand. And that’s what you want! It means you’ve found a strong market fit. Your customers have a strong brand affinity for your products. 

Think of McDonald’s. McDonald’s co-founders, Richard and Maurice McDonald, started the iconic fast food business through a single storefront in California. At this time, Richard and Maurice were the face of the company as they were interacting and creating personal connections with their customers. Fast forward many years later, McDonald’s is one of the largest fast food chains in the world. Now, consumers do not see McDonald’s and think of the original cofounders, they think of the brand, what they offer, and what keeps them coming back again and again. The operating agreement is the corporate governance version of this moment - when your business is more than a hobby. 

Operating agreements set the terms for how your business will function. By specifying how your company will operate, it creates clear expectations amongst you and your business partners. It also protects you from personal liability as it establishes a legal boundary between your personal finances and your business. Overall, operating agreements clearly define your shareholders’ roles and responsibilities in order to set clear expectations and protect your company from bad actors.