Why is it important to create an operating agreement?

I generally get asked why do I need to create an operating agreement for Limited Liability Company (LLC)? Isn't it enough to register the company with the Secretary of State?

My response is if, as the owner of the company, it is important to you to decide how or who runs your company rather than the state legislators then it is critical for you to create an operating agreement.  Registering the LLC simply puts the public on notice that you intend to do business as LLC and it does not tell the world what rules and procedures you intended for running your company or resolving any disputes.  Even though there is no requirement that you must create an operating agreement.  However, creating one allows the owner the freedom to choose a method for running his/her company rather than legislators dictating the choice.  If there is no operating agreement in place, the courts will apply the default rules meaning the rules that the state legislators selected when they enacted the LLC statute.  Although avoiding application of default rules ought to be important, there are other reasons for creating operating agreement as well such as understandings variations between different entities and clarifying terms between parties.

For example, LLC interests can and do differ in management, capital, profits and losses. Whereas, the law for business corporations mandates that shares of capital stock of the same class or series convey identical rights and preferences. If an investor A pays cash for 1000 units in an LLC but investor B contributes only sweat and equity for 100 units, investor A would receive his cash investment plus preferred return on that capital investment before the profits can be shared on the basis of the number of units each investor/member owns at the time of sale. Thus, unless differences between economic interests are defined in an operating agreement, the members may not realize or have intended the consequences from lack of knowledge and/or understanding.

There are various other reasons for creating operating agreement, which are as follows:
• Whether tax distributions should be made on the basis of the allocation of the LLC’s taxable income or economic sharing percentages?
• What happens when the LLC does not have enough cash flow from operations to make the required distributions?
• What happens if one of the members is foreign citizen? (Of course this list is not meant to be exhaustive)

Harsharn K. Makkar practices Corporate Law in the Atlanta area. She can be reached at 404-200-4072 or hersh@makkarlaw.com.