Operating Agreements 101

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NOTE - This post is not legal advice and does not create an attorney-client relationship.  Call (435) 200-5291 if you would like to schedule a consultation with an attorney at Kennedy Art Law, P.C.

Introduction

I usually try to keep these fun and entertaining, but today we have something serious to talk about. Seriously fun!! Okay, not really. But it's important so pay attention.

You spent money registering your business entity. You spent money consulting with an attorney. You spent money registering your trademark. But what if a court ignored your business entity and held you personally liable on a judgment?

If you don't have an Operating Agreement for your limited liability company, all of your money and hard work could have been wasted.

What is an Operating Agreement?

Multi-member LLCs (like bands) need an Operating Agreement.

Multi-member LLCs (like bands) need an Operating Agreement.

Many people who register their own limited liability companies (LLCs) overlook the need for an Operating Agreement, which is basically your business charter. It's an agreement among company members governing the LLC's business operations, financial matters, voting, adding and removing members, and managerial rights and duties. If you are a band choosing to organize as a limited liability company instead of a general partnership, this would be a replacement for your band partnership agreement.

Courts (and the IRS) will look at an Operating Agreement as one factor among many in deciding whether to uphold the "corporate veil" that provides legal separation of your personal assets from your business activities.

Member-Managed vs. Manager-Managed

By default, an LLC is generally Member-Managed. However, an Operating Agreement allows you to specify that you want the LLC to be Manager-Managed.  (Members can also be Managers, but not all Managers have to be Members.) When an LLC is Manager-Managed, you can designate an interim Manager to manage your LLC's affairs in the event that you are unable to do so.

Multi-Member vs. Single-Member

If you are a member of a multi-member LLC (commonly groups like a producers for a film, musicians in a band, or founders of a tech start-up), it's obvious why you would want an agreement that outlines ownership and voting.  You would want your Operating Agreement to:

  • Designate Managers, their fiduciary duties, and legal powers
  • Outline voting procedures - Majority? Unanimous? 
  • Determine percentage ownership
  • Outline duties and responsibilities
  • Clarify procedures for adding new members and "firing" existing members

If you are a single-member LLC (like many freelance photographers, graphic designers, and bloggers and new media personalities) then you may have a few more questions. Single-member LLCs can still benefit from an Operating Agreement.

  • Same benefits as multi-member LLCs.  You would still address all of the issues outlined above for multi-member LLCs.
  • Plan for growth. You would be poised for growth if you end up seeking investors or partners in your business.
  • Protect yourself from third-party claims of ownership. If you collaborate on a project with another person or business, you would make clear that they will not become co-owners of your LLC unless they have met the new member requirements in your Operating Agreement (for example, they can only be recognized as a co-owner after a majority vote and a minimum buy-in amount).
  • Separate yourself from your business for better legal protection. If you establish and follow the procedures set forth in your Operating Agreement, the courts and the IRS are more likely to respect the distinction between your business operations and personal assets.  This means that they are more likely to uphold the "corporate veil" that generally shields your personal assets from judgments related to your business.

Required by Law?

Operating Agreements are very important but they are not required in all states.  Check your own state's corporation laws to find out whether it is required.  While corporate registration with the state does provide some legal protection, the true value in having a corporate entity usually comes from the rights and protections set forth in an Operating Agreement. For example, Utah's state registration portal (OneStop Business Registration) creates an automatic Certificate of Organization for the Articles of an LLC. However, OneStop does not generate an Operating Agreement.

Can I Do It Myself?

DIY legal can be more expensive in the long run.

DIY legal can be more expensive in the long run.

Some people may want to cut corners by downloading an Operating Agreement off of the Internet.  This can cause far more harm than its worth. 

Here are a few things you should consider before you pull up a new browser window for your Google search:

  • Internet forms are usually vague, and they generally do not reflect the complex laws in your specific state or industry.

  • Internet templates may be missing key elements that are essential to protecting your business in the event of a crisis or lucrative sale. They may also include unnecessary terms and legalese that could hurt your interests or lead a court to tossing out the entire agreement.

  • Self-help sites like LegalZoom and Rocket Lawyer do not give you the guidance and customization that you need to make sure that your business is protected.

  • Google will not directly answer your questions or point out danger-zones. My job as an attorney is to make sure my clients have answers and that they can avoid pitfalls.
     
  • It can be more expensive to fix mistakes than to prevent them because "an ounce of prevention is worth a pound of cure."

If you are trying to save costs, you should look elsewhere. Do not cut corners on your Operating Agreement.

Involving an Attorney

A successful business is built on a solid foundation. You need an effective city and state business registrations and a thorough Operating Agreement.  At Kennedy Art Law, we customize your Operating Agreement and do a closing consultation so that you understand the terms of the deal.

Call Kennedy Art & Entertainment Law for more information, or to request a quote on our flat fee business formation services. You can reach us at both (323) 546-4925 and (435) 200-5291.