Forming an LLC can often be simple to do and provide flexibility to business owners. That flexibility, however, can often lead to several issues if you fail to put in place an operating agreement. An operating agreement isn’t required in every state, but if you want everyone within your LLC to know and understand their positions and responsibilities, then you’ll want to have one in place. In California, having one is required by the state.
What is an Operating Agreement?
An operating agreement is a verbal agreement or written document for an LLC that outlines the financial and functional aspects of the business. It is to an LLC what company bylaws are to a corporation: a contract between LLC members establishing the ground rules for an LLC. Included within the operating agreement is basic information about the LLC such as the company’s name, the effective date your company will officially exist, who your California registered agent is, the purpose and expected duration of the LLC, and how the LLC will be taxed by the government.
Why Do You Need an Operating Agreement?
Depending on which state you form an LLC in you may or may not be required to create an operating agreement. California law requires that you have an operating agreement in place for your LLC as an internal document. The reason for this is to provide protection, establish the rules your business will follow instead of the default rules set by California, and help clarify things in the face of financial and management misunderstandings. Even if the state didn’t require you to have one in place, it’s a good idea to sort out these details ahead of time.
Protect Your Limited Liability Status
The number one reason to have an operating agreement in place is to protect your limited personal liability status. Having this in place is the best way to establish your business identity as an LLC instead of a sole proprietorship. A formal written operating agreement provides the credibility you need to be considered an LLC.
Define Your Financial and Management Structure
If your LLC has more than a single owner, it’s vital to document profit-sharing and decision-making protocols. It’s also important to have a system in place for handling a change in membership. Without an operating agreement there can be chaos and confusion in the event of misunderstandings over finances and management. Having the rules in place ahead of time should help clear this up before it happens.
Override State Default Rules
Every state has a set of basic default rules when it comes to operating an LLC. Some of these laws govern your business, unless you establish clearly a different set of rules within the operating agreement. These new rules override the default rules. Many states will automatically assume multiple owners to an LLC will automatically split profits and losses equally, regardless of how much each owner invested. If you want the split in ownership to match how much each person invested, this must be clarified in the operating agreement.
Proof of Ownership
When forming a business there are several documents you must submit to the state. The California articles of organization and statement of information might not include a list of every member. In that case, only the operating agreement, which needs to be signed by all members, will contain the proof of who owns the business. You might need to prove to a third party, such as a bank, that you are part of the LLC when borrowing money or purchasing land.
Information to Include in an Operating Agreement
An operating agreement can be short and sweet, or long and detailed. The information included within is up to the LLC owner(s) who establish the rules. Even though what's contained within can vary, there are a few essential details that should be considered when forming the agreement.
Upon creation, you’ll decide whether your LLC will be member-managed or manager-managed. This is generally decided when submitting the articles of organization (Form LLC-1). If you decide later to switch from one format to another, you must amend this form and submit it to your secretary of state.
It should be clear, regardless of which structure you choose, which member has what authority and responsibility. Establish who makes decisions and who can cast votes when multiple people are required to make a business decision.
How to Add or Remove Members
If a business is growing or changing there should be an official process in place. It’s good to establish ahead of time how to onboard or remove members from an LLC.
Forming an LLC you should establish what percent each member owns. There are multiple ways you can distribute profit, and how you decide to do this within your business should be made official.
Procedures of Transferring Interest
There should be a contingency plan in place for when a member wants to transfer their portion of ownership to another member. This can happen if members are added, or when someone plans to leave the LLC and transfer their responsibilities to someone else.
Dissolving the Business
Eventually the business might reach a closing point. Address what steps need to happen when dissolving the LLC, and how assets and debts will be divided among the members.
How to Create an LLC Operating Agreement
Since an operating agreement is information stored within an LLC internally in California, it can be a verbal agreement between owners of business. To have a more stable structure, it is better to have it written down so it can be reflected upon or adjusted later. There are a variety of elements that can be included, but here are the basics:
You should start with the name of the LLC. Also include the registered address of the office.
Statement of Intent
You’ll need to verify that your agreement is in accordance with California LLC laws. The statement of intent signifies that you’ve checked this box and establishes that the business will officially exist as soon as official documents have been filed with the secretary of state.
It’s a good idea to think about how long your business will be in effect. Depending on the nature of your business, you may define a specific timeframe, or set the duration as “perpetual,” which can last indefinitely. If your business is slated to last more than a single year, you will have to commit to some formalities, such as filing an annual statement with the secretary of state.
California Registered Agent Information
Every business needs to have a designated registered agent, (or agent of service of process). You should include their name and address (in pretty much every legal document).
Make sure to include the nature of your business. You should also add an additional statement like “and for any other lawful business purpose,” in case you need to make changes to your official business purpose later.
How a Lawyer Can Help When Writing an Operating Agreement
Constructing an operating agreement can seem overwhelming, but with the guidance of a business lawyer you can rest assured knowing you have everything vital to include, and the creation process should be quick and easy. We can ensure you have every detail and information necessary to protect your limited liability status. We can also let you know what state laws you can bypass. Reduce the risk and chat with us today for any information you might need.