When starting a business, there are many things to consider. One of the first decisions that you will have to make is what type of entity you want to form. Is a limited liability company (LLC) better than a corporation? What about a sole proprietorship or partnership?
To further confuse things, some states offer the option to form a limited liability partnership (LLP) or professional limited liability company (PLLC). The pros and cons of each type of entity are varied, complicated and require the advice of legal counsel and tax professionals.
Preparing an operating agreement
As an example, let’s say that you and your business partners decide that an LLC is right for your business after consulting with your lawyer and your accountant. Having done so, one of the first things that you will need to do is to work with your attorney to prepare an operating agreement.
What’s in a name? Well, it is usually simply referred to as an “operating agreement” (the reference to LLC is not necessary but is sometimes used). Some states, like Delaware, refer to it as a “limited liability company agreement.” The name of the agreement, however, does not affect any of the rights, duties and obligations of the parties to the agreement.
What is an operating agreement? An operating agreement is an agreement among the members (i.e., owners) of the LLC and the LLC itself. Yes, the LLC should be included as a party to the agreement since it is a separate legal entity (separate from the partners), but more on that later. The major points of the operating agreement address ownership, voting rights, management, money and the “exit.”
Resolve conflicts before they begin
One of the most important functions of an operating agreement is how it works as a vehicle for conflict resolution. Most conflicts arise from a misalignment of expectations.
For example, you might expect to be the CEO of the company and earn a large salary, but so might your partner. Working through the provisions of the operating agreement will allow for an open dialogue about what each of you expect from the partnership, therefore reducing potential conflict. Should a conflict arise, you will be able to turn to the operating agreement for guidance.
What if I don’t have business partners?
One interesting quirk about operating agreements is that even if you are “single member” LLC – meaning you are the sole owner of the LLC and have no partners – it is still advisable to have an operating agreement. But why? One of the main reasons why people incorporate a corporation or form an LLC is for the protections, or “limited liability,” that these entities provide business owners.
As a general rule, the shareholders of a corporation and/or members of an LLC are not personally liable for the debts and obligations of the corporation or LLC. In order to enjoy this protection, the shareholders and members must respect the separate legal status of the corporation or LLC.
One of the elements that a court will look at is whether you have an operating agreement. Since the LLC is a separate legal entity, even if you are the sole owner, you still need an agreement with the LLC to cover how the LLC will operate.
Working with your attorney to draft an operating agreement takes time and requires a lot of from you, the client. However, it is a critical first step in your journey as a business owner. By taking the time to draft a well-crafted operating agreement, you can minimize problems down the road and make sure that everyone knows their rights and responsibilities.