What is an Operating Agreement?
An LLC operating agreement is used by LLC members to address the way in which the business will operate. It is not necessary that your operating agreement be longer than one page and it does not have to be lengthy or complicated. However, it is important that LLCs have an operating agreement to avoid ambiguity in the future concerning (1) the voting rights of the members and managing members, (2) whether a member can transfer her/his interest in the LLC, (3) how a new member is brought into the LLC, (4) how the LLC will be managed (by an outside manager or members) , (5) what happens if the company faces bankruptcy or needs to be dissolved, (6) the salary and benefits paid to the members, and (7) identification of the initial members of the LLC and each of their capital contributions.
Some LLC members will overlook an operating agreement because they feel that they can just rely upon the provisions of Utah’s Limited Liability Act (Utah Code Ann. ยงยง 48-3a-101 to 48-3a-1309). However, Utah law specifically states that to the extent that the operating agreement is inconsistent with Utah’s Limited Liability Act, the operating agreement will be controlling.
Why You Need an Operating Agreement in Utah
The significance of an LLC operating agreement cannot be overstated for several reasons. First and foremost, having an operating agreement in place is the legally correct way to set out the rules and procedures for the operation of your LLC. Section 48-3a-103(20) of the Utah Code defines an operating agreement as "an agreement among the members as to the conduct of the business of the LLC, the relations among the members, including the relations between the members and a manager, and between the members and a manager, and the allocation of profits and losses." Through an operating agreement, an LLC is able to custom-tailor its rules to fit the needs of its members. For example, with a multi-member LLC, you can decide how decisions will be made, set up buy-sell mechanisms in the event a member wants to leave, establish how capital calls will be handled or whether or not new members can join the LLC.
Another important reason an operating agreement is critical to your LLC is because it will not only govern the relationship between the members but the relationship between the members and their LLC. In Utah, laws on these relationships are laid out by the Utah Limited Liability Company Act. However, the Act allows the member to largely agree to whatever terms they see fit in their operating agreement. For instance, in the absence of an operating agreement, a member can withdraw at any time, without consent of the other members. But if the member has agreed otherwise in an operating agreement, the rules laid out in the operating agreement control.
Finally, an operating agreement provides terms that are necessary if there is ever a dispute among the members. If members are unable to amicably resolve a dispute, then the operating agreement may ultimately provide for some form of mediation or arbitration as a way to resolve that dispute. A dispute with your business partners can have a serious impact on your business. It’s far better to avoid costly litigation by agreeing in advance on how your LLC will resolve disputes.
For all of these reasons, the operating agreement should be one of the first documents created before or after you form an LLC in Utah.
Essential Aspects of a Utah Operating Agreement
An effective Utah LLC operating agreement sets clear expectations for all members involved. Ultimately, this helps to circumvent potential problems down the line. After all, LLCs operate using a set of member-driven policies, which can be explicitly detailed in an operating agreement. Below are a few of the primary elements that our lawyers have found to be essential in any solid Utah LLC operating agreement:
Member Roles and Responsibilities – Member roles and responsibilities are extremely important. Without clearly defined duties, liabilities and expectations, disputes between members are bound to happen. Every member of the LLC should have a clear understanding as to what they’ll be doing – and what others in the company will be doing.
Voting and Control – Voting plays an integrative role in any LLC. Members need to have a clear and concise understanding as to how decisions will be made. Are all members allowed to vote on decisions? Will voting be done in person or over email? Do members have the right to refuse or abstain from voting on certain issues?
Profit Distribution – How will profits be distributed to members? While it may seem like a straightforward detail, entrepreneurs may vastly disagree on how profits are spent or saved. Thus, laying out everything in writing is ideal.
Contingency Plans – What happens if one of the members leaves and cannot continue to fulfill their role? This is an unfortunate possibility, but one in which your operating agreement should have a plan.
How to Create an Operating Agreement in Utah
Like every other state, Utah requires each limited liability company to maintain an operating agreement. This is a crucial document, as it establishes the rights and expectations of the members in regard to the company. The operating agreement and the Utah Limited Liability Company Act generally do not legally bind members in case of discrepancies or conflicts. Utah considers the operating agreement, as well as state law, to be advisory in nature for the members. Ultimately, it is the members’ obligations to abide by the internal agreements that each made with the others. The members make their own obligations.
The language of the operating agreement does not need to be freeze-dried, and the members should keep it fairly simple. Legal terms and phrases that are not grounded in common language will only confuse managers and members of the LLC. However , the operating agreement should also be clear about each members’ interests in the LLC and how profits are to be distributed. How profits are to be distributed is left up to the members to decide. If distributions are to be made annually, the operating agreement should spell that out clearly, otherwise profits will be distributed quarterly according to the rules of the Utah Limited Liability Company Act.
Although the member may include amendments in the operating agreement, it must be specified so the members know which provisions of the operating agreement have been amended. Amendments can be made by any member of the LLC, regardless if that member is a man or woman.
The Utah Secretary of State’s office has published a resource for business owners who need help creating an operating agreement. That resource can be found at http://corporations.utah.gov/llc.html#operating-agreement.
Mistakes to Avoid
Operating Agreements for LLCs in Utah: Common Mistakes to Avoid
One of the biggest mistakes people make when creating an Operating Agreement is not setting one up at all. Sometimes people mistake another document as the LLC’s Operating Agreement. This is problematic on two levels: (1) Your LLC could lose protections that it would otherwise have with a proper Operating Agreement (or if you had named the right document as your Operating Agreement); and (2) Your failure to follow the formalities of adopting an Operating Agreement could jeopardize your protections as a member of an LLC.
Another mistake is not updating the Operating Agreement when changes happen. The consequences can sometimes be fatal in the eyes of the law if you don’t properly adopt an amended Operating Agreement after changes happen. Maybe some of your members left your LLC, or yourselves were appointed or removed as Managers. Maybe you need a new person to handle your LLC’s books, and needed to remove a previous person who was the bookkeeper. With every major change that happens, you need to formally (1) vote to adopted a new statement of management, officers and members; and (2) amend the Operating Agreement as well.
In Section 12.2, we set forth what a valid vote on a resolution looks like, in case you decide that your LLC needs to vote on certain matters at any time. This section is still in its draft form.
Amending an Operating Agreement
The option to modify an operating agreement is rarely used. Most members of a Utah LLC believe that the existing terms – whether in a standard template or a custom drawn agreement – are sufficient for their needs and do not require modification. But there are always exceptions. Members may find, decades into an LLC’s life cycle, that the terms of the LLC’s operating agreement are out of touch with the current financial or business realities of the company. Alternatively, an LLC may experience a change in ownership among its members that necessitates a corresponding change to the terms of the operating agreement. To address either of these situations, the Utah Limited Liability Companies Act allows for the modification of an existing operating agreement. Any individual or entity with authority under the terms of the operating agreement – or with the consent of all members – may propose to the remaining members a modification of an LLC’s operating agreement. If all of the remaining members approve the proposed modification of the operating agreement, it shall be deemed adopted, and modifications need not be filed with the Division of Corporations and Commercial Code. (Note: members may, through a provision in the operating agreement, give one member or a small group of members the power to approve amendments. When drafting a new Utah operating agreement or modifying an existing one, the author recommends that the operating agreement contain a provision describing the process by which the members may adopt an amendment . ) If the proposed modification requires a vote of the members or a supermajority or special voting class of the members, then it shall be binding on all members, even those who did not approve the modification. Some operating agreements – including template agreements – attempt to overrule this principle by requiring modification of the operating agreement by a unanimous vote of the members. Though the Utah LLC ACT does not require adopting operating agreements to be unanimous, such a provision is enforceable as long as the provision was not the product of fraud or overreaching. If one or more members of the LLC do not consent to the modification, than any member or manager with authority under the operating agreement (or any person specified by the operating agreement) may petition the district court to authorize adoption of the proposed modification. If the court finds that: then the court may order the modification to be adopted. The court may also, if necessary to eliminate an uncertainty, construe or provide guidance on the meaning of any term in the operating agreement. A modification adopted by court decree shall not be treated as an act of the members or managers for any purpose (such as triggering a buyout right). Therefore, even if the operating agreement gives the members a buyout right based on a two-thirds vote in favor of modifying the operating agreement, it will not trigger the buyout right if not all of the members voted for the modification. (For more on minority buyout rights, see section "Majority Oppresses Minority: The Tightrope of LLC Buyout Agreements" in this article).