Without an operating Agreement, an LLC is governed by the “default rules” set out by Utah statute. This is where things may get ugly because there may be so many unconsidered extenuating circumstances.
Our guest post today is from Darren Hansen to explain more on protecting your business.
Why your LLC should have an Operating Agreement
by Darren E. Hansen
What is an Operating Agreement? An Operating Agreement is a formal legal document entered into by the members of a Limited Liability Company (LLC) that establishes the structure of your company and creates the rules that govern your business. Utah, like many states, does not require an LLC to adopt an operating agreement upon creation. As a result, many new LLC’s never adopt an Operating Agreement. As explained below, however, without an Operating Agreement your business and you personally, are then exposed to significant business and legal complications and risks that would otherwise be avoided.
Benefits of an Operating Agreement An Operating Agreement contains everything from mundane clauses on how to vote and the powers of members (and managers) to how to handle many extenuating circumstances the business may face. Without an Operating Agreement, an LLC is instead governed by the “default rules” set out by Utah statute. Trusting Utah law to govern your LLC can have unintended and unpleasant consequences.
For example, let’s say Jack and Jill form a Utah LLC and do not adopt an Operating Agreement. Jack contributes $10,000 to the capital of the company and Jill contributes nothing. They agree orally that they will split the distributions 75% to Jack and 25% to Jill. However, the Utah default rules provide that LLC distributions happen in equal shares among the members. As a result, although Jack and Jill wanted otherwise, to comply with Utah law, their LLC will divide distributions equally between them.
Aside from superseding Utah’s default rules, a well drafted Operating Agreement will also address many issues an LLC may face and detail how the LLC will handle those issues when they arise such as:
- How the LLC will be managed (member managed or Manager managed)
- What powers are reserved to the members versus the managers (if any) and what may be done without a vote, versus what requires a vote
- Establish how to admit new members, and who approves new members
- How to handle if a member wants to leave (i.e. no one can leave, right of first refusal back to the business, valuation ownership, etc)
- How to handle the death or incapacity of a member (i.e. estate inherits the membership versus LLC 2 buys the outstanding membership from the estate, etc.)
Absent an Operating Agreement, you may find yourself partners with a total stranger when your partner decides to sell his interest, or the Manager could mortgage the business to the hilt, or infighting could erupt when a partner wants to leave but nobody can agree on the value of his interest. A well drafted Operating Agreement acts as a “prenup” for your LLC, addressing issues before they arise so that, when they do arise, you and your partners can resolve the issue without it tearing the business, and your relationship with your partners, apart.
Finally, in addition to addressing common areas of friction, an Operating Agreement will help your LLC accomplish its primary function: limiting your personal liability. Many businesses operate under a business entity in order to limit their personal liability. The last thing a business owner wants to worry about is a creditor or litigant coming after their personal assets as a result of something the business did. When considering whether to hold business owners responsible for the liabilities of the business, i.e. “piercing the corporate veil”, Courts consider numerous factors, many of which revolve around whether the business was legitimate or merely used as a cover to commit fraud. An LLC with an Operating Agreement is one sign, among others, that the business is legitimate and that the owners should be insulated from personal liability for the debts of the business.
If you own an LLC but don’t have an Operating Agreement, get one. If you have an Operating Agreement, review it. Does it properly reflect how you want your LLC to be run? If not, change it. Don’t let the absence of an Operating Agreement be what destroys your business.
Darren E. Hansen started the Law Offices of Darren E. Hansen upon his return to his ancestral homeland of Cache Valley after practicing complex commercial litigation and business law in Washington, D.C. For any business or litigation questions you may have, feel free to contact him at for a free consultation: email@example.com