When you start a business, there are many things to consider, from funding to startup structure. You don’t want to jeopardize your startup’s future because you didn’t conduct adequate research or familiarize yourself with the most fundamental concepts.
Creating a good operating agreement is a critical step that many startup founders overlook. While you might think you can skate by without a real agreement at the beginning, that can be a big mistake. Tackling this right away is one move that could save you a lot of money and frustration in the long run.
Here’s everything you need to know about an operating agreement.
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Here is the content that we will cover in this post. Let’s get started.
- 1. What is an Operating Agreement?
- 2. Why You Need an Operating Agreement
- 3. How to Construct an Operating Agreement
- 4. 6 Sections Your Startup’s Operating Agreement Should Include
- 5. Organization
- 6. Equity Structure
- 7. Membership Interest
- 8. Classes of Membership Interest
- 9. Management and Voting
- 10. Voting
- 11. Capital Contributions
- 12. Distributions
- 13. Ownership Changes
- 14. Anti-Dilution Protections
- 15. Buyout
- 16. Dissolution
- 17. Specifics of LLC Operating Agreements
- 18. Single-Member LLC
- 19. Multi-Member LLC
- 20. When Does Your Operating Agreement Need to be Amended or Changed?
- 21. How to Make Changes to Your Operating Agreement
- 22. LLC Operating Agreements
- 23. Conclusion
What is an Operating Agreement?
An operating agreement is a legal contract that sets out how a company will operate. This applies to C corporations and LLCs (limited liability corporations). These are the bylaws that lay out responsibilities, how disputes are settled, and more.
This differs from the articles of incorporation which are a public document forming the company and registering it with the state and jurisdiction they will do business in and laws they will be governed by.
In a nutshell, an operating agreement documents the way you and your co-founders, and future shareholders will agree to operate.
Some of the most popular states for startups to register their businesses in include:
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Your operating agreement will be used to settle legal disputes. Investors and other incoming shareholders will want to see this document. You may also need to provide copies as proof of your authority to make decisions on behalf of the company.
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Why You Need an Operating Agreement
Startup founders who are continuously balancing activities and corporate difficulties rarely have peace of mind. Operating agreements can help alleviate some tension by establishing and enforcing guidelines developed and signed by all parties.
Another reason why operating agreements are essential is that they safeguard you and your co-founders from future disagreements, which are inevitable. They also offer protection from personal liability. It’s vital to keep in mind that all legal contracts exist to protect you if something goes wrong.
How to Construct an Operating Agreement
As a legal document, an operating agreement should be properly handled. Ensure it includes a statement of intent, emphasizing that your startup complies with all applicable laws in the state in which you operate in.
The operating agreement must be in writing, signed by all members. The members interests, contributions, and obligations must be clearly specified together with the management structure.
An operating agreement should include the following as a minimum:
- The name of the startup
- The startup’s legal address
- Principal business location
- The startup’s stated mission
- The startup’s founders
- How much time or other resources must each owner devote
- Is it possible for a party to sell their portion of the startup to a third party
- Criteria and procedures for adding new owners in the future
- The fiscal year and how it is calculated
- How are bank records to be kept, who has access to them, and when can they be viewed
- Any financial investment necessary by any party to launch the startup, as well as any further contributions
- How should profits, losses, and cash outflows be allocated
- Rights of first refusal
While you may be able to get away with an operating agreement template for a little while, you’ll get busy, and not devoting the time to get this right early can be disastrous.
It is always wise to use the help of an experienced corporate law firm for matters like these which can be so influential.
6 Sections Your Startup’s Operating Agreement Should Include
While operating agreements can vary between startups, there are typically six sections to these agreements:
- Management and Voting
- Capital Contributions
- Membership Changes
Below is a synopsis of what each section might contain.
The organization part is all about getting your startup off the ground.
- When did it come into being?
- What are the members’ names?
- What is the ownership structure of the company?
- You should also specify how many ownership units each individual has.
This section of the operating agreement determines who will own what portion of the startup’s equity.
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This is where you determine the proportion of each member. This number can change when people join the startup and leave. You should also determine which management interest percentage each member gets. This means that you have to establish whether each person is an economic shareholder or whether they are also active in management.
Classes of Membership Interest:
What are your and your co-founders’ membership classes? Are there common interests, non-voting interests, or preferred interests? Companies can include several financial arrangements; therefore, this section is governed by your decisions to organize your startup and your co-founders.
Management and Voting:
The directors are who runs your startup every day. Who will take which executive titles? Decide what you want and have it recorded in this section.
You must also define how often you have management meetings, what they look like, voting methods, manager tasks and responsibilities, how and when you will fire and replace people.
Consider who will be allowed to vote and who won’t be allowed to vote on company decisions, as well as what they can vote for. Some grant voting rights based on the percentage interest of a member, whereas others choose to allow some groups limited votes. You also have the right to vote, cast a vote for the majority, or even offer management powers.
Each company has a capital account, a general ledger account that records the invested capital and earnings of the member. Capital donated can be:
- Rendered services
- A pledge note
- A mix of the above
If one of your members donates something besides cash, you have to recognize and record the item’s monetary value. You must also determine if members keep contributing capital or if it’s only an initial investment.
Different corporate structures may have different rules on this. The purpose here is to lay out who gets what percentage of distributions. This may be in direct correlation to their ownership percentage, or not.
You need to determine how you will add or remove owners and indicate when members can transfer their shareholdings.
This section covers the protection of the percentage of interest of each member. It allows owners to:
- Oppose the issuance and admission of new share interests
- Limit capital calls
- Purchase any type of interest to maintain their share
You need to consider what will happen if a shareholder dies, becomes incapacitated, gets fired, or goes bankrupt. This section may allow other shareholders to purchase that person’s interests. If you have decided to add buyout rights, outline how a buyout will occur, the buyout price, and the payment conditions.
Include how you will determine the value and price of these shares, such as if you would need to get an independent third-party appraiser to determine that number.
Even though it’s something you aren’t thinking about yet, you need to describe under what situations or events your company would be dissolved. Also, you should explain how your company’s assets are handled and how assets are distributed if your company dissolves.
Specifics of LLC Operating Agreements
The operating agreement for your LLC will vary slightly based on the type of LLC you have.
Here’s a rundown of what that entails.
Establishing an operating agreement for a single-member LLC may seem absurd, but it is essential. This is because operating agreements don’t merely specify how members interact. They also provide an overview of the startup’s structure.
For example, the parts of the Organization, Distribution, and Dissolution sections above relevant to a single-member LLC should be included in a single-member LLC operating agreement. It also indicates that you are legally separate from the LLC as an individual, even if you are its sole member. This separation shields you from legal and financial repercussions if something goes wrong with your startup.
You’ll need a multi member LLC operating agreement if your LLC has more than one member. In this situation, you can choose between these two options:
- A multi member member-managed LLC operating agreement
- A manager-managed LLC operating agreement
The differentiator is whether you and your co-founders will be engaged in the startup’s day-to-day operations. If that’s the case, choose the first option. If not, go with the second option.
When Does Your Operating Agreement Need to be Amended or Changed?
An operating agreement should be an ongoing contract, meaning it should never be considered complete. You’ll need to make updates or amendments to it from time to time.
Here are scenarios that could lead to a modification in your operating agreement:
- You’ve added a new person to your team.
- A member has resigned
- You’ve gone from being managed by members to being managed by managers, or vice versa
- You make any significant managerial or budgetary adjustments
- You want to adjust the distributions’ percentage allocation
- You’ve altered the distribution schedule
- You’ve increased your capital
How to Make Changes to Your Operating Agreement
Making adjustments to your operating agreement is easy, as you make the changes and have all appropriate shareholders sign off on them in writing.
In your original operating agreement, you may have established a procedure for making adjustments. If this is relevant to your situation, stick to the procedure, or your changes won’t be valid.
Get a great attorney. While you can draft your own operating agreement, it’s always a good idea to have it reviewed by an attorney before you and your co-founders sign it. Even bootstrapped startups should invest the money in this scenario because a legal mistake in your operating agreement could be disastrous for you and your co-founders down the road. You want to be able to trust the advice you are given no matter where you seek help.
LLC Operating Agreements
An LLC’s operating agreement functions the same way as any other startup’s by regulating the LLC’s operations.
It should include the same essential elements, such as:
- A statement of intent
- The startup’s purpose
- The time frame for operation
Other things to keep in mind in the operating agreement are:
- How the LLC will be taxed
- How much capital members can invest
- How new members will be admitted
A startup has a clear and direct structure thanks to their agreement and bylaws. These agreements ensure the seamless operation of the organization. These are the basic operating and procedural standards that apply to everyone in the startup, including employees, executives, and shareholders.
A startup must be legally compliant even though an operating agreement is not always required by law. The startup’s compliance with the law is ensured through an operating agreement.
You don’t have to file your operating agreement once it’s completed. Verify the criteria of your state, check your local laws. If you need information on prerequisites for the formation, you can find it on the Secretary of State’s website.
Retaining a file or binder for critical LLC papers, such as your operating agreement, is a wise choice, in addition to digital storage. Local laws may also cover how long you must retain records. Maintain a copy of the operating agreement for your records and distribute copies to your cofounders.
It’s an excellent idea to review and consider changing the operating agreement after significant corporate events. With the consent of all appropriate shareholders, an operating agreement can be changed at any time.
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