This post originally appeared on Entrepreneur.com - #StartingABusiness
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Every limited liability company (LLC) needs an operating agreement to serve as its backbone and ensure that partners are treated fairly. However, it can easily be inaccurately written or leave out important sections that have a massive impact on the future of the company. In minor cases, an LLC operating agreement mistake or failure can merely result in an inconvenience. In more extreme cases, it can result in a contentious legal disagreement or even result in the collapse of the company.
So why is it that so many LLC operating agreements fail, and what can you do to prevent this from happening in your business?
The Components of an LLC Operating Agreement
Let’s start by reviewing the key components of an LLC operating agreement. The operating agreement is meant to outline each partner’s ownership stake, as well as their duties as founding members. While you don’t need to follow an exact formula, these are the main sections you’ll need to address:
- Organization. Why is the company being created, and who is creating it? This section will detail the members of the LLC, as well as the structure of ownership. In other words, what percentage of ownership will each member have?
- Management and voting rights. This section will detail how the company is managed. For example, there may be owners of the LLC who don’t take an active role in managing the business. Here, you’ll also detail voting rights and how voting works.
- Funding and capital investments. Who is contributing capital to the LLC? This section will also detail how money could be raised for the LLC in the future.
- Profit and loss distribution. This section will detail how and when profits and losses will be distributed to LLC members, including money and other company assets.
- Operational requirements. This section will detail how the company will operate, including the responsibilities of each member. It may also assign authority or restrictions for certain activities, like signing checks.
- Process for adding or removing members. If you need to change your membership structure by adding or removing members, how will you approach it?
- Dissolution and/or LLC endgame. This section will explain under which conditions the LLC can be dissolved, and sometimes the endgame plan for the company.
Common Points of Failure
There are several ways your LLC operating agreement can go wrong, but these are the most common reasons for failure:
- Missing sections. Skipping a section may be convenient when drafting your agreement, but it could end up hurting you in the long run. For example, if you envision a future where your LLC members remain consistent forever, you may avoid drafting a section on adding or removing members; however, you’ll regret missing it when you need it.
- Ambiguity. Sometimes, members write sections ambiguously intentionally, to provide more wiggle room for the future. However, ambiguity opens the door for too many potential exploitations. If you don’t concretely define your intentions, it can be used against you.
- Loopholes. Legal loopholes are always a potential problem. If you aren’t careful, you could establish a section that could be manipulated for someone else’s gain.
- Stagnation. The circumstances dictating your business’s operation are certainly going to change, especially if the business continues operating for years. You need to update the operating agreement periodically, typically at least once a year, or the terms you created initially will no longer be relevant.
Why Are These Mistakes So Common?
There are a few reasons why LLC operating agreements end up insufficient or working against their creators. First, entrepreneurs and their partners are often eager to get the business started. They want to take care of all the formalities as quickly as possible so they can start generating revenue. Accordingly, they cut corners and don’t take their operating agreement as seriously as they should.
Money could also present an issue. New entrepreneurs are often strapped for cash and want to save money any way they can. Accordingly, they don’t spend the money necessary to have their operating agreement reviewed by a lawyer. It’s also common for entrepreneurs to put too much trust in their partners. They might choose a partner because they’ve worked with them before and believe everything will work out fine one way or another. But even in cases where you have faith in your partner’s abilities and loyalty, it’s important to put the tenets of your partnership in writing and establish legal consequences for violating those terms.
If you’re forming an LLC for your business, especially if you’re working with other partners, it’s vital that you spend time creating and polishing your operating agreement. Work with a lawyer and take your time, even if you’re on a thin budget or are pressed for time.