Why Operating Agreements Matter

The foundational documents of a limited liability company, particularly the Operating Agreement, matter greatly to the business. I could have called this post “Why Bylaws Matter”, as the contents of this post apply to corporations and LLCs alike. In fact, I may go ahead and write the “1b” version of this post for corporations.

Many businesses labor over which type of entity to create – an LLC, a partnership, a corporation. While an important determination, once the entity is chosen, often little attention is paid to the underlying company documents.

Businesses routinely ignore or inadequately address the contents of their Operating Agreement, or fail to have one entirely. Still worse: using a template that not only doesn’t address your needs, but must by its nature be so universally applicable that it does little more than give you and the company legal generalities you don’t understand, don’t need, or are simply wrong for the business.

What are Operating Agreements?

An Operating Agreement is a document an LLC uses for internal governance, establishing financial and managerial rights and responsibilities for company members.  A corporation’s functional equivalent is its Bylaws.

Operating Agreements create rules governing how the LLC holds company meetings, elects officers or a board of managers/directors, how and whether distributions are made to members, the protocol for a liquidation event or an event of dissolution, and on and on…  These are not small matters.

Many clients come to me after having received a form Operating Agreement. When creating the business, their attorney sent the Operating Agreement off for signature, with little or no discussion of the Operating Agreement’s use in the company.

The business owner may know little, or nothing of the Operating Agreement’s contents, and may not even know where the document is located. Often, the business and its owner engage in practices that contradict the provisions that they’ve signed up for with the form agreement, or skip actions that are called for in the document (meetings and meeting notice requirements are popular missed-items).

You’re asking – why do any of these things matter? Who cares if I hold an annual meeting required in the Operating Agreement, particularly if I, the business-owner and operator, don’t care?

Why Operating Agreements Matter

Operating Agreements matter for two reasons: 1. they provide members with a document they can turn to in good times and bad, with  a defined protocol as to how to proceed when making financial and managerial decisions, and 2. Operating Agreements serve to define how an LLC is separate and apart from the individual.

The first reason is self-evident – it is important to know how the business is to be run, and by whom.  The second reason relates back to the purpose of creating a legal entity: LLCs are used (corporations too) as methods of risk and liability allocation. LLCs shield the individual from liability – whether the individual is an owner, principal, officer or director.

When acting appropriately under the guise of the LLC, liability generally remains with the LLC and not with the individual actor. If, however, a business ignores its own internal governance provisions in the Operating Agreement, courts (and perhaps more specifically, a smart litigator) will question the legitimacy of the LLC. All of a sudden, the liability protection that caused you to form the LLC in the first place may not be there when you need it most.

How to Right the Ship

1. Read through your Operating Agreement. If you don’t have an Operating Agreement – skip down to #4.

2. When reading through the Operating Agreement, write down questions you have, and legal terms of art that you don’t understand.

3. Pay particular attention to provisions that require you to do things as an organization, like annual meetings, notice requirements, filling board or officer positions — and, write down any provisions of which you were unaware or have ignored, or those provisions that need further clarification.

4. Consult with an attorney experienced in business law and ask the questions you have on the document from #2 and #3 above, and how to fix any errors or omissions in action to date. If you don’t have an Operating Agreement, talk with a business attorney about tailoring an Operating Agreement for your company.

Getting in good habits early is always the best course of action, but it’s never too late to make a fresh start.  Take some time to learn about your own company’s governance in its Operating Agreement, its required actions and protocols, and you might just save yourself from the personal liability you were trying to avoid all along.

For some additional information on Operating Agreements, check out the following:

- The SBA’s brief post entitled “Operating Agreements; The Basics” and the post entitled “Crucial Forms for Your LLC: Article of Organization and Operating Agreements