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Why tech startups and businesses should have an operating agreement

Since the new US corporate tax rates are so competitive with other jurisdictions, it is no surprise that there is a spike in LLC registrations. Starting a business with friends, family and other people may look like an easy thing until problems arise. That is why it is advisable for a tech startup or any other business to have an operating agreement in place before or after registering a limited liability company, or LLC.

What is an operating agreement?

An operating agreement is a legal document that is similar to a corporation’s articles of incorporation and governs the internal operations of the business. It outlines the basic terms of an LLC, such as who are the members of the LLC, what percentage of the business each member owns, how membership can change, how the LLC can be dissolved, the organizational structure, management structure, and voting rights of the members.

All members of the LLC are required to sign the operating agreement as an indication that they agree to its terms and conditions. (More details on LLC operating agreements here)

Is the operating agreement mandatory in all states?

The operating agreement is not mandatory in all states. Only New York, California, Missouri, Delaware and Maine specify the need for an operating agreement at the time of incorporation. However, it is considered to be a key document that should be put together when setting up a limited liability company in any state.

Why is the operating agreement important?

When drafting the operating agreement, the members think seriously about its contents because it governs all aspects of running the business. It allows the members to make their own rules and specifications about how the business will be run. Once it is signed, the operating agreement becomes a binding set of rules which every member must adhere to and respect.

An operating agreement can also protect the members from any personal liability if there is belief that they are operating as a sole proprietorship or a partnership.

What is the risk of not having an operating agreement?

If an LLC operates without an operating agreement, it will then run according to the default rules of the state which tend to be too general and may not be suitable for the business. For example, two partners may contribute 70% and 30% capital. It cannot be assumed that the profits will be shared 70:30 – it has to be clearly spelled out in an operating agreement. If this is not specified in the agreement, the default state law may stipulate that all profits must be shared 50:50, despite the difference between each partner’s capital contribution, and this may create tensions and disagreements.

What are the contents of the operating agreement?

The operating agreement usually contains the following key sections:

Organisation

This section contains the names of the members and their units of ownership at the point of company creation.

Management and voting

This section spells out how the company is managed and how the members vote. The company may be managed by the members or by some members and other managers, so the section explains clearly the authority that the members and managers have over the company. If decisions are made through votes, then the section explains how votes will be allocated to each member, e.g. one member one vote or one vote per unit of ownership. For decisions that will have a major impact on the business, the agreement can specify what minimum number of votes is required before adopting the decision.

Capital contributions

This section covers how much money has been contributed by members to start the LLC and how additional money will be raised. This may be a loan or money from members in exchange for more units of ownership.

Distributions

This section makes provision for how profits and losses are shared among the members.

Membership changes

This section deals with how new members will be added and how members may be removed and whether members can transfer their ownership of the company. This will take into consideration what happens under different situations such as death of a member, bankruptcy of a member, divorce of two members, imprisonment of a member, etc.

Dissolution

In this section the members agree on the circumstances in which they may dissolve the company.

Other topics

Beyond the six key sections discussed above, the operating agreement may add other sections depending on the circumstances of the company. For example, the members may agree to hold periodic meetings, place restrictions on check signing, or agree on how internal disputes will be handled.

Is the operating agreement cast in stone?

The operating agreement can be updated from time to time as the company grows and its needs change, or as new challenges arise and have to be included in the agreement.

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