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Operating Agreements: The Rules Of Play In The Game Of Business

WHAT ARE OPERATING AGREEMENTS?

You are in the middle of a board game. The competition is hot, and your opponents are getting desperate. You engage forward with a strategic, but questionable move. Your opponents become upset and explain that the move you just made is contrary to the rules of the game. We have all had that awkward moment while playing a board game when all the other opponents vehemently deny a potential game-winning move for us because we invented our own rule. In the world of board games, a wrong move is typically chastised, and then forgotten. Yet, in the business world, not only are these game winning, yet prohibited moves awkward, they are sometimes illegal and can cause serious consequences to those involved. So, how can you avoid making these mistakes in your business, firm, or company? How can you ensure that your business conduct is ethical and legal? Much like board games, a booklet of instructions and rules supports every business. A book of rules and instructions ensures that a game is played properly, efficiently, and legally. This booklet of directives in the game of business is called an operating agreement.

Operating agreements are legally binding documents that outline the rules, proceedings, parameters, instructions, directives, guidelines, orders, and other procedures that are required to effectively and legally operate a company. They are also an official declaration that your limited liability company (LLC) has been formed. They vary depending on the size, the shape, and the purpose of the company. Operating agreements come in two distinct forms: Manager-Managed and Member-Managed. Manager managed LLC’s give total authority to one or more of the managers over all the members. The manager(s) become agents of the company, and typically serve as the company’s CEO (Chief Executive Officer) or COO (Chief Operating Officer). Member-managed companies, on the other hand, give authority directly to the members at-large, allowing them to make the regular, day-to-day decisions of the company as they vote on decisions that the business should make. Returning to the board game analogy, both manager-managed and member-managed respectively would represent two distinct “games,” each with diverse rules of play.

Irrespective of which type of operating agreement your company decides to adopt, one thing stands unchangeable: when a member and/or manager of a company disobeys, disregards, or ignores the rules as outlined in their operating agreement(s), they are held legally accountable for those actions in a court of law. Much like playing a board game, when a participant disregards a rule, they are required to turn back and replay their move in a rule-abiding way. Similarly, business members who make illegal decisions or moves not in accordance with the operating agreement are required to retrocede and to make restitution. Often, restitution is only enforced after a lawsuit is brought against the offending member, or manager. The court will rely upon the language and provisions in the company’s operating agreement to decide restitution. Because the law totally and completely depends on the company’s official agreement of rules, it is crucial to seek professional legal counsel when drafting and preparing your company’s operating agreement(s). Individuals will most often have their attorney draft and prepare this agreement on their behalf in order to protect their business, members, and manager(s) from potential pitfalls.

WHAT DO I NEED TO INCLUDE IN MY OPERATING AGREEMENT?

Whether you are preparing your own agreement, or you ask your attorney to prepare it for you, it is vital to include eleven things to protect your company. The following provisions and language are crucial to incorporate into your operating agreement:

            [1] The Formation of the Limited Liability Company

In one of the first sections of your operating agreement, and if your company is a limited liability company, you will need to officially state that your LLC has been formed, what its purpose and function is, its powers, its registered office, any statutory agents, and the term length under which the agreement is valid. While this section will be short and more of a formality, excluding it can be detrimental. It gives both the members and a future judge context as to the purpose of the company, as well as the forthcoming rules and instructions.

            [2] Capital Contributions

This article is necessary for the management, allocation, limitations, and instructions for all the finances and funds that move through the company. Specifically, it provides the amount of assets each business partner or manager receives, and the number of units afforded to each member. In an operating agreement, units are a measurement of equity, and are subject to change over the years of the company’s existence. In addition to these, this section also includes what happens when there is a delinquent member of the company, and how to treat that member according to his or her misconduct. This section becomes important in a lawsuit and gives the judge specific steps to take should there be a dispute against a delinquent member of the company. This section is irreplaceable. It safeguards your company’s goodwill and gives the boundaries for the accounting and finance that will take place in your business. This section is also the place to include answers to all questions about equity, vesting, partnerships, and shareholding. Many companies desire to provide an opportunity for growth within their company. To properly provide these opportunities for your company’s members, you will need to include strict instructions in this section on who, what, and how much equity to vest.

            [3] Management

The Management section profiles the respective roles and responsibilities of the manager and members. Without this section, there is no standard that the manager(s) and the members are expected to live up to. It lists the overarching responsibilities of each member and manager, and prohibits acts for each member and the manager. It outlines the process of resignation, should either a member or the manager desire to resign, as well as other independent activities that are pertinent to the company. Much like a board game, this section defines the players, their roles, purpose, and importance.

            [4] Payments and Distributions

The Payments and Distributions section explains everything that pertains to cash flow and liquidation. In any company, all cash flow, revenue, and liquidated assets must be accounted for. This section concerns the distributions of net available cash flow and liquidation, as well as amounts withheld, inclusions of unit holder(s), and all federal and state law limitations on distributions. This section prohibits any commingling of funds, and other financially fraudulent behavior. It will become an important guideline should any member or manager engage in dishonest behavior.

            [5] Allocation of Profits and Losses

Similar to the previous section, the allocation of profits and losses outlines the do’s and don’ts of finances, specifically of taxes, as well as how to allocate either the company’s profits or losses. This section is a type of budget for the company, allowing them to know beforehand how they will allocate their revenue and prioritize their financial needs.

            [6] Liabilities, Rights, and Obligations of Members

In any company, there are liabilities that all the members share, along with rights and other specific obligations. This section supplies a list of all the things that could go wrong, all the things that the members individually reserve the right to do, and all the responsibilities that are expected of each member. This section also provides the rules and structure for voting and for how members are expected to come to a consensus about decisions that are relevant for the company. More than anything, this section provides a more exhaustive list of responsibilities for each member, just as the management section does for the manager.

            [7] Liability, Exculpation, and Indemnification

In accordance with the last section, this section outlines the liabilities the entire company shares as a whole. It provides a security against legal liability for the company’s actions, as well as the compensation that is expected for any harm and loss incurred to the company. This section may require, for example, that a certain amount of money be paid if a certain member is to mismanage and commingle funds. This will provide some type of guidance for the court to follow should a dispute arise.

            [8] Books and Records, Reports, Tax Accounting, and Banking

Just as the title of this section suggests, this article gives structure and rules to the keeping of the books, records, reports, tax accounting, and banking. It requires that there be some level of order and organization when it comes to the finances, taxes, and banking of your company. Most companies also require the assistance of a professional accountant or CPA for the managing of their funds. This section is where that mandated provision would be found. It is also the section that stipulates how and where the company’s books and records are kept.

            [9] Admissions and Withdrawals 

This section is simple. It explains the process for people outside of the company to become members, and how current members may withdraw from the company. It will be a relatively short section, but is important to include.

            [10] Transferability

In conjunction with the Capital Contribution and the Allocation of Profits and Losses sections, this section deals with all the procedural necessities for members or managers to transfer all or a portion of their units to other members, or manager(s). Imagine that you are a current member of a company who wishes to give a portion of your units to another member. This section will outline exactly how and when to make that transfer happen. It explains if or when you should designate an assignee to make the transfer happen. It will also explain what happens if you are a member experiencing divorce, and what you should do in that or all other situations. Should you fail to adhere to all the proper steps of transferring your units, you will be at risk of legal action. This and the other sections seek to protect you and your company against the negligent transfer of shares or units of your entity.

            [11] Dissolution and Termination

Lastly, it is crucial to include the instructions of how to handle the dissolution and termination of your company, should it occur. This section will give specific guidelines on what paperwork, distribution, winding up of funds, and other pro forma that are necessary to complete as your company dissolves. It also explains what to do should you have any deficit or bankrupt capital accounts. It may be that you never need to use this section. However, in the case that your company does dissolve, this section will be inviolable to you as you deal with the stresses dissolving a business incur. 

HOW DO I PREPARE AN OPERATING AGREEMENT FOR MY BUSINESS?

Operating agreements provide the proper structure to protect any business from questionable and illegal business moves. The above provisions offer a glimpse into the necessary matters to address in your operating agreement. As you contemplate the options that are right for you and your company, let Sumsion Business Law be a part of your decision. With over 30 years of legal experience, Sumsion Business Law stands ready to protect your business from unethical and unlawful business practices. We may not be able to help you win board games, but when it comes to the game of business, we are prepared to help you win any challenge you face!

Disclaimer: This website, blog post and all related material is for informational purpose and is NOT legal advice; hence it should not be acted upon without seeking advice from a lawyer licensed in your state or jurisdiction. This website, blog post and all related material does not create an attorney-client relationship. Sumsion Business Law cannot ensure the accuracy of any third-party links.