During the initial stages of business formation, people tend to focus on the positives- the revenues they expect, how well the business will do, how much they will expand and so on. At this point, it is hard to imagine what can go wrong. This optimistic outlook is a great help in starting a multi-member or single-member LLC. Even so, you should be careful about throwing caution to the wind when it comes to setting the law. You see, a house is only as strong as its foundation and whatever precedence you set now will probably follow you right till the end. It is thus better that you have a say in what happens when things take a turn for the worse (if they ever do).
What is the Operating Agreement in California?
Your business needs to have some ground rules for it to succeed. As you start, you may want to take a flexible approach but this can work against you in the end. For example, you may decide to share profits based on something other than capital share. If you choose to introduce capital share as a basis some time down the line, this change would face opposition from people who would lose based on this outcome.
An operating agreement helps you spell out the courses of action you will follow right from the start. In an internal document, you stipulate how you will manage the business, who will be involved in making decisions, how you will accept and dispel members, how long you will operate and other matters that are pertinent to your success.
It may seem like a lot of work. But here is the thing. When businesses are in their infancy stages, members do not expect any squabbles to arise. Once the money starts flowing and profits/ losses take over, it becomes much easier for people to disagree on matters. Thus, having LLC operating agreement guidelines on how to go about these events would work for you rather than against you.
Are operating agreements required for LLCs in California?
You may have heard that for some states, having such an agreement is optional and members are free to do as they please. However, that is not the case in California as the law (California Corporation’s Code §17050) requires all LLCs to have such an arrangement, be it oral or written. Thus, if not for any other reason, you should have it to remain compliant with the current laws.
Why does an LLC need an operating agreement in California?
For one, California mandates all LLCs to have one and failure to comply with this requirement would land you in quite a great deal of trouble. Additionally, having one enables you to enjoy the following benefits:
- You decide the rules from the start. As the business operations continue, you will find yourselves being faced with more complex issues that affect your financial as well as legal standings. For example, how will you vote on decisions? You may find some people wanting to have more power than others and without rules in place, it would be quite a mess. Instead of going through ad hoc processes each time something major is nigh, you can get things sorted from the beginning.
- You can benefit and protect yourself by avoiding going the default law route. The state has its own rules that pertain to LLCs and where you do not have any rules set for your business, you will have to use these. Note that these laws are pretty general and using them can make some of your members feel disgruntled. Unfortunately, there is not much you can do about this outcome. The only way to prevent such an occurrence would be to have an agreement in place or to use alternative dispute methods when things go south.
- It enables you to show who has ownership in the business. Your formation documents do not go into who owns the business. An agreement can spell this out, even showing how much each person has contributed to the venture and how much power they have. You need an LLC operating agreement for official purposes, such as when you want to borrow money from a lending institution.
- You can further protect your personal assets using this agreement. A mistake people often make is assuming that once they form an LLC, they can now rest assured that people cannot get to their personal finances. However, this is not the case. If you would like to enjoy such protection, the divide between you and the business should be clear on paper and in reality. You must thus come up with an agreement that stipulates what the business activities are, thus protecting yourself in the event you get sued.
Can you open an LLC without an operating agreement?
You can go ahead and do so. However, given that LLC operating agreements California are a requirement by the state, doing so would put you in danger of violating the law. Additionally, you would be putting yourself at risk of losing your protection from personal liability. Also, where you own the business with other people, you would have to use alternative dispute resolution methods or go down the default route if anything were to go wrong. Thus, opening your business without such protection would not be in your best interests.
How can an operating agreement be drawn up?
You have a few options in this case:
- You can choose to go at it yourself based on the issues that seem relevant to the members. It is important to remember that generic laws apply to any loosely worded documents or companies that do not have set agreements. Thus, this option may put you at risk of having your rules overridden if you are not sure what you should include.
- Hiring an attorney is another option. It applies to people who deal with highly technical issues where costly loopholes can occur. It also works for people with little experience in drafting documents. The downside to this approach is the high cost.
- The last option is using an operating agreement template or operating agreement for LLC generators. It works for people who would prefer avoiding high legal costs while still coming up with a free operating agreement template that would hold up in a court of law.
What should be included in an operating agreement?
To avoid leaving loopholes which members can exploit to the detriment of others in the event of a wrangle, your operating agreement of LLC should be quite detailed. It should include:
- Company Details operating agreements LLC should include the name, address, and purpose of the entity. The point of contact’s address and the names of members should also be clearly shown in the document.
- Structure- how many people own the business? You should show how many people have an interest in the business and how big their capital contribution is. Please note that interest does not always equate to the capital contributed and the choice depends on the members of the organization. On this, you should also outline how much power members have and how profit-sharing will take place.
- Management- you also have to decide how you will manage the operations, which can be done by managers or by members. The information included here should coincide with that in your formation documents.
- Voting which members have a right to vote on issues and how much voting power do they have?
- Capital how much money will members contribute? Often, it comes down to interest in the business. Please note that failure to include this part may leave the business open to members who would not contribute any capital.
- Profits/ Losses Sharing- how will you divide the revenues?
- Changes- what will you do when a member wants to leave? Can people transfer their interests? Do members have the right to dispel other members?
- Dissolution what happens when the business can no longer continue? How will you terminate it?
What happens if you don’t have an operating agreement?
Without an operating agreement limited liability company in place, you will be at the mercy of default laws. These take effect when you have a loosely worded document that does not address the state’s key concerns or when you do not have an operating agreement for an LLC in place. The laws are quite generic and they do not work to the benefit of businesses in most cases. Your attorney is best suited to advise you on the implications of these laws, though we will cover a few to help you get the general idea.
Take the example of voting processes. If you are not clear about these in your agreement, you will have to go by the state’s default definition law. In this case, members would enjoy power based on how much interest they have in the company. Also, to change the operating agreement or business formation documents, members would have to pass a unanimous vote. For other issues, members could decide based on the option that gets the most votes. This Default Judgment in California may not augur well with you.
What is the default law?
These are the rules used to govern an LLC without an Operating Agreement. For example, even members with 1% interest in the company can vote and if they vote against the majority over amendments to business formation documents, the motion cannot go through. Given the implications of default law definition, you are better off setting rules now rather than later when things could get messy.