You’re in the arcane phase of setting up paperwork for your small business and you and your partners (if applicable) have decided that a Limited Liability Corporation (LLC) is the best means to protect your assets and secure tax advantages. You know that you need to file articles of incorporation with the state.
But an “operating agreement” is different.
You aren’t mandated to have one in place. It might be tempting to skip this step amidst the thousand and one other things you have going on as a startup. But before you do, consider the reasons for having an operating agreement.
Operating agreements vs. articles of incorporation
Let’s begin with the way an operating agreement differs from the articles of organization.
The latter is documentation filed with the state. The former is internal for the business itself—hence, why it’s not required. But as an internal document, the operating agreement outlines how members will handle operations and dispute resolutions. When disagreements come—and be assured, they will—there is a clear set of rules in place that can be referred to.
These rules apply to a wide range of matters, from as mundane as the official mailing address for the business to how profits and losses are split up between the members. The operating agreement will define governing law, arbitration, the conduct of meetings and their minutes, indemnifications and a lot more.
But I’m in business by myself. Do I still need an operating agreement?
Again, you don’t need one in the strictest sense, but it’s still better to have one than not. And it starts with the basic reason you chose to file your business as an LLC to begin with: liability protection. The LLC protects your personal assets from being seized in a bankruptcy or other legal dispute. But that presumes that your personal matters and business affairs are truly being kept separate. The operating agreement for a sole proprietor can prevent them from mixing personal funds with those for the business.
In other words, it ensures that your personal affairs and your business remain separate entities.
If a court were to decide that was not the case—that there was a “piercing of the corporate veil”—then your personal assets could be taken in a lawsuit.
The operating agreement provides 2 more advantages that sole proprietors can benefit from. The first is that it defines a clear plan of succession if you die or are otherwise incapacitated. Also, the agreement prevents your business from being subject to default rules by the state.
The default rules are set up for businesses that don’t have operating agreements. While the state tries to set them up to function in the way the typical business would prefer, that may not work for you.
Let’s use the line of succession as an example.
A natural default would be that if the owner dies, the business is inherited by the spouse and/or the children. What if you’re setting up the business for your teenage child to run one day, but as of now neither they—nor your spouse—has the aptitude to run the business if you’re gone? Perhaps there’s a close associate that can manage the business and your wishes more effectively for an interim period of time.
Whatever the situation, your business has unique needs and an operating agreement allows you to address them in the manner that’s best for you.