1. How to Draft an Operating Agreement for Your Small Business
2. Types of Business Formations
3. The Importance of an Operating Agreement

A small business operating agreement is a document used by a limited liability company (LLC) to outline the operations of the company and other important aspects of the business.

How to Draft an Operating Agreement for Your Small Business

When drafting an operating agreement, the first thing to consider is how much of the business each member will own. The percentage awarded to each member is usually directly proportionate to the amount of capital they provided to the business. When a member invests more into the business, their investment ownership percentage is usually higher. However, the members of an LLC can award ownership percentages however they wish.

A member of an LLC who is a member of a minority group or is a woman might own 51 percent of the business for a strategic purpose. As long as the ownership percentages are clearly outlined in the agreement, the LLC members can determine how they are split. You'll also need to determine the voting responsibilities and rights. If the members of the LLC disagree over a certain situation or decision and can't come to an agreement, the situation may need to end in a vote. When the operating agreement specifies the voting rights of each member, you can avoid issues and disputes about who holds more weight.

Ownership percentages generally determine the voting rights, but some LLCs choose to provide equal voting rights to each member, regardless of what percentage of the company they own. In this section of the agreement, be sure to include the mechanism for breaking a tie. The operating agreement must spell out the expectations of the managers and members. It's very important to outline how the business profits and losses will be distributed to the members. In this section, outline the schedule for distribution of profits and losses.

When you answer these questions at the time of formation, you can avoid a lot of disputes and headaches. These decisions may also impact the taxation of the business.

The members of an LLC may wish to exit the business at some point, so the operating agreement should outline the procedure for ownership transfers or exits. You may want to specify that the LLC can buy out the exiting member, or you might choose to allow any member to sell their ownership interest in the company. Include details on what will happen if one of the members no longer has the physical or mental capacity to serve in this role.

Finally, you'll want to outline the procedure for dissolving the LLC. In this section, include details on how the business will be liquidated, if necessary.

Types of Business Formations

One of the benefits of forming an LLC is the fact that this action creates a separate legal business entity. As a result, the owners of the LLC, called members, are shielded from being held personally responsible for business debts and liabilities. The taxation of an LLC is also more flexible. A single-owned LLC will be taxed by default as a sole proprietorship. An LLC that has multiple owners is taxed as a partnership.

The Importance of an Operating Agreement

It is in the best interest of every LLC owner to draft an operating agreement, even if doing so isn't a requirement in the state in which the business will operate. According to information from the U.S. Small Business Administration (SBA), the operating agreement exists to:

  • Protect the business.
  • Prevent management, verbal, and financial disputes.
  • Suit the needs of its owners.
  • Govern the internal operations of the business.

After the members of an LLC sign the agreement, it becomes a legal document that binds all parties to the items they agreed upon in the terms. Before you agree to any terms of an operating agreement, it's important to understand what you are agreeing to with the other members of the LLC.

Although taking time away from growing and running the business may seem like an impossible task, it is critical to make time to draft an operating agreement that will be valuable to the partners and members of the LLC. Some business owners dread drafting such a document, but failure to create and implement an operating agreement could have significant implications.

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