A Primer on Operating Agreements
An operating agreement is essentially a contract between the members of a business, typically a limited liability company (LLC). It is an extensive document that describes the inner workings of the business and the day to day expectations of all parties involved. Both small and large businesses can benefit from having an operating agreement, however the document is a requirement for businesses formed as an LLC.
The operating agreement defines things like ownership shares, the role of each member, the basic hierarchy of the business and how to handle the additional or departure of members . It covers the structure and financial organization of the business.
Because the operating agreement is an important component of an LLC’s legal structure, it must be drafted carefully and accurately. The language used cannot be ambiguous as these documents are subject to legal scrutiny. Even minor errors could have devastating effects on your business. For this reason, it is important that you have a qualified and experienced attorney draft your LLC’s operating agreement.
Elements of an Operating Agreement
The key components of every operating agreement include ownership structure, management roles and control, allocation of profits and losses, and processes. The production of financial statements must be specified. Additionally, the process for dissolution must be defined. It is recommended that a buy-sell agreement be included in the operating agreement.
Ownership structure refers to the allocation of the equity (ownership interest) in the business. In a single member LLC, the single owner might have 100% equity. However, with multiple members and other ownership arrangements, the percentage of equity the owner has can vary. For example, in some cases the percentage of equity relates to the member’s contribution to the LLC. In other cases, the allocation may be split 50/50 between the members. One of the alternative ways of allocating equity in the LLC is based on pro-rata voting power. For example, if an LLC has 8 members and each member has an equal vote, then each member has 12.5% of the voting power of the LLC (100% divided by 8). In such a case, the allocation of equity and voting power is the same.
Management is typically vested in the members. If one or more members have management authority, their involvement in daily operational decisions should be set forth in the operating agreement. Control of the business typically involves the powers of the manager. From a legal standpoint, all decisions usually require a majority vote, unless otherwise stated. The voting requirements in the clauses should be set out. For example, if there are four members, the business may require a majority vote of 3 to 1. In this case, unless the members agree otherwise, the views of the minority member would not matter. Every decision would require a majority vote and the minority member could be out voted. However, if all members must agree, then the minority member’s vote is required to make a decision. Companies with multiple levels of ownership may designate the highest level of ownership as the decision making body. The members may decide that in such cases the higher tier will make decisions affecting all levels of ownership.
The allocation of profits and losses may be the same as the members’ initial contributions to the LLC or may be allocated based on the percentage of voting power.
Why Hire an Operating Agreement Attorney
When it comes to running a business, it’s always best to consult an expert when drafting an operating agreement. Though you may think of it as an expense, a lawyer can help you save a lot of headaches and heartaches down the road. A lawyer will help you avoid liability issues and will be able to explain relevant laws and tax implications that an individual without a legal background may not be aware of. He or she will know if your state has laws that differ from typical laws. Experienced lawyers deal with these issues every day, so they will be well-versed in the laws and how they apply to your situation. An operating agreement can be complex and far-reaching, but a lawyer who is experienced in creating them will be able to understand your communication style and understand your expectations, which they will be sure are reflected in the final draft of the operating agreement. When it comes to lawsuit or fine avoidance, an operating agreement is also essential for any business. A lawyer can help prepare an operating agreement that will be binding in any court of law. This can help you avoid hearings and headaches down the line. While it’s not required, hiring a lawyer to create an operating agreement is highly recommended. A lawyer will seek to understand how your business operates and will work with you to ensure that all of the business owners and members are satisfied with the agreement.
Mistakes to Avoid when Drafting an Operating Agreement
Many owners try to save money by downloading an operating agreement off the internet. This is very dangerous, even for single-member LLCs, because these agreements are general templates and not written to conform to your factual situation. They are missing critical terms that you need to operate and protect your ownership of your business.
A very common error I see is that some operating agreements will include an odd number of member owners that provides for an uneven vote on all decisions. If the members don’t have a majority, or a 2 out of 3 vote requirement, then it can be difficult to make a decision. An even more common problem is there being no requirement for there to be a vote on a major decision. This can occur when members can unilaterally request a vote that is not required. Even if a vote is required amongst members, the votes may not measure up to the strict requirements of corporate formalities. This can cause a court to overrule a vote as not being valid.
A third common mistake is the operating agreement not requiring a drawing of capital accounts and defining each member’s ownership percentage interest. The capital account should be increased by the amount of capital contributions made by each member and the account should be decreased by distributions made to each member. Without sufficiently defined capital accounts, the distribution of assets upon dissolution could be disputed between the members.
Selecting the Appropriate Attorney for your Operating Agreement
When selecting a business lawyer to draft your operating agreement for your limited liability company, we recommend that you find an attorney with relevant experience and specialization. Unfortunately, some lawyers are generalists, meaning, they do a little bit of everything but have little experience in any particular area . When it comes to an operating agreement, you should find a lawyer that has a good amount of experience specifically with these agreements. Otherwise, you could be paying your lawyer to gain experience on your dime. You should also look for a lawyer who specializes in business formation and business law. A specialized lawyer will be able to spot potential issues that a generalist might overlook.
Financial Questions Regarding Hiring a Lawyer
The costs of hiring an operating agreement lawyer can vary widely. As with any business service the cost will be contingent on a number of factors including the complexity of your LLC and the experience of the attorney you choose. Your base cost starts with the lawyer’s hourly rate. Experienced attorneys will be able to help you draft an LLC operating agreement for a couple of hundred dollars in a few hours. A less experienced service provider may charge upwards of $1,000 an hour. You should expect a range of $500-$1,000 in costs for a basic LLC operating agreement in the state of New Jersey.
As you start to ask the right questions with a prospective attorney you will get an idea of their expertise and what they will be charging you. You should absolutely not enter into an agreement with someone who you think may be over-charging you. This will often lead to extra fees which can compound fairly quickly. The best way to evaluate your service provider is to ensure that you are simply paying for the value they provide. Your LLC operating agreement tax attorney should not be calling you at every turn in the process – they should already understand your needs and how they will be able to help you with your LLC.
Case studies and examples
Displaying why you need an operating agreement lawyer is easy. Either you have gone through a legal issue and resolved it due to having a great operating agreement drafted by and with the help of a lawyer, or you have gone through a very legal situation that has led to problems for you and another member because nobody had a well-drafted operating agreement. It is that simple.
Take this example right from our own practice: A young entrepreneur who had invited several individuals into his venture – as in family members with small ownership percentages – finally took the advice of one of his partners and retained us to draft and execute an operating agreement . Now, the company is making money and the entrepreneur and his partners want to sell the business for a profit. Well, the operating agreement we drafted has the members split evenly in dissolution decisions. This came into play now, because there are no deadlocks in voting.
We like to think that the operating agreement we drafted for that entrepreneur is now protecting him from any other owners who feel they are not making as much of a profit as they should or are under-compensated for their efforts.