Laying Down the Law: Do I Need an Operating Agreement?

This post is the eleventh installment of “Laying Down the Law” – a series where our attorney friends at Troxel Fitch give legal advice for budding entrepreneurs. View the previous post about Making a Successful Exit here.

Limited liability companies (LLCs) have become a very popular entity type for entrepreneurs  when choosing the right form for their company.  However, getting an LLC set up properly entails much more than simply filing articles of organization online with the Colorado Secretary of State.

One of the first things we advise clients to do is get an operating agreement in place.  We get asked all the time, “Do I really need an operating agreement?” which is often followed by “Ok, but can’t I just do this myself or do I really need to get it professionally drafted?”

In this edition of Laying Down the Law, we will address both of these issues, explaining why it is so vital to have an operating agreement in place, and exploring some of the considerations involved with drafting your own operating agreement vs. hiring a professional to do so.

Maintaining Limited Liability

One of the primary reasons that an entrepreneur forms an LLC is to limit their personal liability.  If an LLC is formed properly, and later sued, the owners of that LLC are protected from losing their personal assets because the LLC is seen as a separate legal entity from the owners.

This means that if you properly set up your LLC, and that LLC subsequently loses in a lawsuit and faces a monetary judgment, the opposing party will only be able to satisfy that judgment against the assets of the LLC as opposed to your personal assets. Thus, your personal home, your car, and your 401(k) are safe.

However, if an LLC is not set-up properly and is then sued, the court can has authority to do what is called “piercing the corporate veil,” and come after the owners personally, regardless of the LLC being in place.  Some of the many factors that courts consider are: (i) the absence or inaccuracy of corporate records; (ii) the concealment or misrepresentation of members; (iii) and the failure to observe corporate formalities in terms of behavior and documentation.

Having no operating agreement affects all of these factors:

• The operating agreement is typically the first, and most important, corporate record that an LLC keeps. It sets out how the company will operate, how money will be distributed, and who has decision making authority.
• Second, it sets out exactly who the owners of the company are (owners of LLCs are called “members,” not shareholders) and how much of the company they own.
• Finally, an operating agreement serves as proof that the LLC is operating as a separate and legitimate business because it defines the rules the LLC will operate under. This combination of factors is vital to maintaining limited liability protection while operating the business.

Self-Drafting vs. Hiring an Attorney

Now that we have cleared up the importance of having an operating agreement in place, let’s address another common question we get: whether or not hiring a business attorney to draft your operating agreement is really necessary.  Long story short, its certainly possible to draft your own operating agreement, but let’s explore some of the pros and cons of each route so you can make the best business decision for your specific circumstance.

When I talk about drafting your own legal documents, I am assuming that an entrepreneur would use some type of template or pre-drafted agreement found on the internet.  If you are considering simply drafting an operating agreement from scratch, this is extremely unwise and you should at least take the time to get on Google and find an operating agreement template to start from (there are many).

Using a template and trying to put together an operating agreement for yourself is certainly better than doing nothing, and worth considering if an entrepreneur is truly unable to afford hiring a business attorney.

However, it is analogous to going into a shoe store and just grabbing one off the display rack.  Sure, you could get lucky and happen to grab one that fits you perfectly.  You could also grab one that is so ill-fitting you end up injuring yourself trying to wear it.

Legal documents are like shoes, the customized fit is more important than the style or logo.  Just as grabbing a shoe off the rack might result in a shoe that is too big and falls off, or a shoe that is too small and hurts your feet, grabbing an operating agreement off the internet might result in one that doesn’t fit your business, and subsequently can’t protect it – or worse, hurts it.

While you can rectify a bad decision on footwear by taking the shoe off, or buying a new pair, rectifying mistakes with your corporate operating documents is not so easy, nor is it cheap.  If your company happens to fit in with the type of company that the template was made for, it will work great and save you money up front.

But what if your operating agreement doesn’t address who has ultimate decision-making authority when two equal partners disagree?  This can result in a business stalemate where nothing can be done.

What if it doesn’t address what happens if an owner dies?  This can result in a distant relative inheriting an ownership interest in your company, and then forcing you to liquidate.  These, and many other factors, can doom a business before it starts, or derail a once successful business simply because the owners were short-sighted in their assessments of business expenses.

While legal planning can be a tough expense to stomach at the outset, it becomes an even less attractive expense when you have to pay an attorney ten times that amount to resolve a dispute in litigation after the fact.

The decision of whether to draft your operating agreement yourself, or to hire professional help, is one that each entrepreneur must make for themselves in light of the risk and expense involved.  It is probably the most important document for your corporate legitimacy, as it controls significant aspects of your company’s operation and profit.  Like anything else in life, you get what you pay for.

The question you must ask yourself is this: how much is protecting my business worth to me?

If you are starting an LLC, make sure you get an operating agreement in place.  If you are cash-strapped and feel comfortable drafting your own, there are many free options available on the internet.  If you are in a place financially where it makes sense to hire a business attorney to draft one for you, we (and many other attorneys) would be thrilled to help you.

ABOUT TROXEL FITCH:

Troxel Fitch, LLC, is a law firm designed to meet the needs of businesses operating in the hyper-competitive modern marketplace. By combining low-overhead operations with efficient technological solutions, Troxel Fitch is built to provide you with responsive, professional, and affordable legal representation.