Why Your Small Business Needs an Operating Agreement

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Imagine that a few friends or business associates decide to start a business. They rent office space, hire employees, begin locating new customers, and take other necessary steps. However, they do not draft an operating agreement to formalize the way their business will be run.

How will a future dispute be handled?

As explained below, without an operating agreement, disputes will be significantly harder to resolve, as there will be no set of agreed-upon rules and contingencies. In addition, decisions could be made regarding company operations that contradict what the owners originally intended.

What Is an Operating Agreement?

An operating agreement is a contract between the business owners (a.k.a. members) that establishes the ground rules or framework for how a limited liability company (LLC) will operate. In particular, it sets out the rights, powers, and responsibilities of each owner in relation to each other and the LLC itself. An operating agreement also helps preserve the LLC’s limited liability status, which, in turn, helps protect the owners from personal liability for the company’s debts and obligations. 

An LLC does not need to have an operating agreement under Arizona law. However, it is highly recommended for the reasons stated above. An operating agreement can be written or oral, but written agreements are much preferred in order to limit any legal disputes. It can be extremely difficult—sometimes impossible—to prove the terms of an oral agreement, as the parties will probably have different recollections about what was agreed upon.

Arizona does not require an operating agreement to contain any specific provisions, as long as the agreement’s terms are in accordance with state law. That said, to help avoid and resolve future disputes, an operating agreement should cover several areas. These include:

1) Each member’s percentage of ownership and capital contributions.

These are usually related, but can be based on other factors as well, such as the work responsibilities of individual members.

2) How new members are admitted to the company.

An operating agreement should outline this process, including details such as how new members make their first capital contributions and how much they are expected to contribute annually.

3) How and when important company decisions are made.

Rules regarding decision-making should include (a) how many members must agree, (b) which decisions, if any, do not need other members’ approval, and (c) the extent of each member’s voting power.

4) Members’ and managers’ duties.

The operating agreement should specify whether the company will be run by the members or managers, who is responsible for developing and implementing corporate strategies, how day-to-day operations will be handled, and the overall responsibilities and authorities of each member.

5) Profit and loss distribution.

The agreement should explain when and how profits and losses are distributed, whether by individual members’ contributions, tax brackets, or some other criteria. 

6) What occurs when a member leaves the LLC or passes away.

This should include what happens to the member’s ownership interest and who must approve any transfer of ownership.

7) Rules governing member transactions with the company.

This will prevent, for example, a member or manager from binding the company to a loan or other contract with that manager or member that the other members do not approve of.

8) Dissolution procedures.

If the LLC needs to be dissolved, this section explains how that will occur, including how and when members will receive payment.

Finally, make sure that the operating agreement actually imposes obligations on the company’s business partners. If it does not, the agreement may not have the intended effect in a dispute. For example, in In re Ehmann, 334 B.R. 437 (Bankr. D. Ariz. 2005), a bankruptcy court held that, because an LLC’s operating agreement imposed no obligations on its members, it was not an executory contract. 

What Happens if an LLC Does Not Have an Operating Agreement?

An LLC in Arizona that does not have an operating agreement is subject to the Arizona Limited Liability Company Act (ALLCA), which went into full effect on Sept. 1, 2020. Without a properly drafted operating agreement, the rights and obligations of all members and managers of the LLC are determined by the default provisions of the ALLCA. In effect, the statute becomes the LLC’s de facto operating agreement.

What this means in practice is that the company might not end up being run in accordance with its members’ wishes. Even if the LLC has an operating agreement, if the agreement is silent on any provision of the ALLCA, the statute will govern that aspect of the company’s operations—which, again, may or may not be what the members desire. As a result, although an operating agreement does not have to reflect what the ALLCA provides, it should cover every area that members do not want the ALLCA to cover.

What Are Common Disputes That an Operating Agreement Can Help Resolve?

A well-written operating agreement can help resolve all kinds of business partner disputes, such as:

1) A member’s alleged misconduct or poor performance

2) The terms of the partnership agreement

3) The owners’ relative workloads

4) How to spend the company’s money

5) Partnership distributions

Contact Counxel Legal Firm

If you would like to draft an operating agreement or need help resolving a business partner dispute, contact us at (480) 744-6621 or at request@counxel.com. Don’t forget to check out the good things that others are saying about the services they received from Timothy Coons on Google.

This article is intended for informational purposes only and does not constitute legal advice for your specific situation. Use of and access to this article does not create an attorney-client relationship between you and Counxel Legal Firm. Please contact request@counxel.com or (480) 744-6621 to request specific information for your situation.

*Conveniently located off the 101 Freeway and the US 60 in the middle of Phoenix, Scottsdale, Tempe, Chandler, Gilbert, Mesa, and Queen Creek!

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