Chapter 4: Startup Essentials
The next stack of paper you’re going to need is an Operating Agreement. An operating agreement outlines roles, powers, and responsibilities of business partners, as well as serves as the template for governing disputes and transfers of ownership. I mentioned earlier how a business partnership of mine completely fell apart due to a disillusioned member, and became further complicated by a lackluster operating agreement. I use this story as a cautionary tale as to how important it is to have a rock solid operating agreement with contingencies, even if you trust your partners. The only exception to this is if you’re filing an LLC as a sole proprietorship, or with yourself as the only owner. Since the point of an operating agreement is to govern inter-partner relationships and responsibilities, you don’t need to write a novel if you don’t have any business partners.
If you’re filing an LLC without any business partners or just need a framework to start, use THIS template as an easy, simple operating agreement to get you started.
When it comes to more complex business structures, operating agreements can vary wildly, from 10 to over 200 pages. If you’re trying to set up a complex LLC structure with a large number of partners and differing roles, it’s going to be easier to just go hire a lawyer to meet your needs perfectly. However, if you’re just getting started, or even if you are working with an attorney, there's a few key things to keep in mind when setting up your first operating agreement:
General Information
An operating agreement is generally an internal document, and isn’t required to be reported to any state or federal agencies. However, you will need an operating agreement in order to create a business bank account, so it’s important to include some general information. This includes the name of the business, the registered address, the purpose of the business, and most importantly, who the business partners are and their percentage ownership interests. This percentage split will be used to determine who will have access to the company bank account, and which partners are eligible to leverage their personal credit to obtain business credit (a partner must have >15% ownership interest to leverage personal credit for business credit).
Management Structure (Member vs. Manager)
As we mentioned, an LLC needs to choose between being member or manager managed. The operating agreement is another place where you will want to illustrate this distinction, and elaborate on any specifics. If the LLC is member managed, include a clause about meetings of the members and voting procedures for important decisions. If the company is manager managed, make sure to designate the manager in the agreement and specifically outline their roles, responsibilities, and authorities.
Roles & Responsibilities
As we’ve mentioned, it’s crucial for your business partners to have different skill sets, abilities, and responsibilities. Your operating agreement is the perfect opportunity to get specific about who is going to worry about what. If your partners are acting as a CFO or CMO for example, outline briefly what those job descriptions look like, and what powers come along with them. A CFO may need complete autonomy over the checkbook in order to manage payroll and expenses, while a CMO may be required to get approval from the CEO or other partners for marketing expenditures before moving forward. Any inter-partner differences in power, ability, or authority should be outlined specifically in the operation agreement so as to limit any confusion and streamline any possible disagreements moving forward.
Distributions & Profits
Your operating agreement should also outline how company profits are to be handled and distributed. If your LLC is being taxed as a partnership (most common), company profits pass through to the shareholders based on percentage. This should be mentioned in the operating agreement in addition to the timing and size of distributions, and who will be in charge of overseeing the process.
You may also have a need to distribute profits in some manner other than directly to the owners based on their ownership interest. You may have partners who’s equity is vesting, or you may opt to distribute zero profits for a certain period of time and reinvest in the company. Any decisions regarding profit distribution are generally allowed as long as all partners agree and it is stated specifically on the signed operating agreement.
Transfers of Ownership
Another important section of your operating agreement should outline governance and procedures for transfers of ownership interest. When a partner sells their ownership interest or something else transpires (like the death of a partner) it’s important to have some guidelines to follow to streamline the process. One common stipulation for transfers of ownership interest is that the remaining partners will retain the right of first refusal. Right of first refusal means that the remaining partners will have the option to purchase the ownership interest from the exiting party prior to it being offered for purchase to the general public or any other third party. This can be a super important addition to your operating agreement, since bringing in an unwanted new owner years after founding could be a tricky situation to navigate.
Template Walkthrough (Part 1)
Template Walkthrough (Part 2)