If you’re starting a business and forming a limited liability company (LLC) in California, you must have an operating agreement. It’s not filed with the state but must be kept in your records.
An operating agreement is particularly important if your LLC has more than one owner, or member, as it establishes ownership shares, profit and loss distributions, and member roles and responsibilities.
Why You Need an Operating Agreement
You need to have an operating agreement to comply with California law, but a smartly drafted operating agreement can also help you in many situations, such as when your LLC merges with another business or a member is no longer capable of working.
The operating agreement establishes each member’s ownership share in the LLC, profit and loss distribution percentages, and how proceeds will be divided if the business is sold. An operating agreement also defines how decisions and member disputes will be resolved.
It also defines each member’s role and responsibilities and how the LLC is managed, clarifying who oversees which aspects of LLC operations.
Without an operating agreement, California laws will apply by default, and disputes may have to be settled in court, which can have serious negative consequences for the business. The fact that you are not in compliance with the law by not having an operating agreement could cause legal issues for the business and its members.
What Should the California Operating Agreement Include?
The California Operating Agreement serves as a foundational document that outlines the internal operations of an LLC within the state. To ensure smooth governance and minimize potential disputes, it’s crucial to understand the key components this agreement should encompass.
- Each member’s rights and responsibilities: In California, unless specified in the operating agreement, all members have equal rights regardless of capital contribution. The operating agreement should clearly outline responsibilities like attending meetings, day-to-day operations, and any specific roles a member might have.
- Capital contribution requirements for each member: Clearly define the amount or value of each member’s contribution and the timeline for those contributions.
- Procedures for adding and removing members: California law allows LLCs to add or remove members if it’s stipulated in the operating agreement. The agreement should clarify the process and conditions for such changes.
- Events affecting a member’s interest: Specify what happens if a member sells their interest, becomes incapacitated, dies, or if there are conditions under which they might become bankrupt or insolvent. California law permits transfer of financial interest, but unless the operating agreement allows, management rights are not transferable.
Management and Voting:
- Management structure and roles of members: Specify whether the LLC is member-managed or manager-managed. In California, it defaults to member-managed unless stated otherwise.
- Voting rights of each member: Detail how votes are allocated. California typically operates on a per capita basis (one member, one vote) unless specified otherwise.
- Rules for meetings and voting: Define quorum requirements, notice procedures, and whether voting can be done remotely or in writing.
- Managing potential conflicts of interest: Establish a conflict-of-interest policy ensuring fair business practices.
- Allocation of profits, losses, and distributions: Specify the ratio or method. In the absence of specification in the agreement, California assumes equal distribution.
- Provision for periodic financial audits or reviews: Define how often and by whom financial reviews will be conducted.
- Tax treatment of the LLC: Remember, California LLCs might be subject to an annual minimum franchise tax.
Changes and Amendments:
- Amending the operating agreement: Stipulate the process and any supermajority requirements.
- Guidelines during transition events: Outline management protocols during major transitions like mergers.
- Sale or merger conditions: Define circumstances and processes under which the LLC might be sold or merged.
Disputes, Legalities, and Policies:
- Dispute resolution: California recognizes clauses mandating mediation or arbitration. Define your chosen process.
- Non-compete and confidentiality: California generally doesn’t uphold non-compete clauses for employees, but confidentiality agreements can be enforced.
- Indemnification and liability limitation: Specify the conditions under which members are indemnified.
Record Keeping and Communication:
- Record-keeping requirements: In California, LLCs are required to maintain certain records, like a list of current and past members and managers. Specify where and how these records are kept.
- Decision documentation: Detail how decisions will be recorded, stored, and communicated.
Company Information and Dissolution:
- Business purpose: While some states allow a general purpose, it’s best to be specific for clarity.
- Agent for service of process and office: Every California LLC needs an agent for service of process within the state.
- Dissolution: Detail the process to dissolve the LLC, keeping in mind California’s requirements for notice, asset distribution, and filing articles of dissolution.
- Winding down: Provide procedures for the liquidation of the company’s assets upon dissolution.
Remember, while the above elaborations align with California’s guidelines, it’s essential to consult with a legal expert or attorney to ensure the operating agreement’s enforceability and compliance with all state-specific requirements.
How to Draft a California Operating Agreement
You can find operating agreement templates online from services like ZenBusiness, which will ensure the standard legal language and allow you to fill in the blanks. You’ll probably be able to find free templates online as well, but it’s advisable not to use those as they may include errors.
If your business has multiple members, you should consider having an attorney draw up your operating agreement. An attorney will ensure that all bases are covered, and all members’ rights are protected. They can also include language that is specific to California laws.
This could cost anywhere from $500 to $2,500, but it could save you much more.
Articles of Organization vs. Operating Agreement
The operating agreement should not be confused with your LLC’s articles of organization. The articles of organization officially form your LLC with the state and include no information about member roles or financial interests.
Also, the articles of organization is filed with the state and part of the public record, while an operating agreement is kept in your LLC’s records and referred to as needed.
Keep Your California Operating Agreement Up to Date
It’s a good idea to review your operating agreement periodically. Circumstances change, and the safest approach is to ensure your operating agreement is fully up to date. Generally, your operating agreement will state that members have to vote to approve amendments to the operating agreement.
Don’t Skip the Operating Agreement
You’re required to have an operating agreement in California, but the wise entrepreneur would never do business without one anyway. It’s a document that could be critical to the future of your business. You may think a dispute will never arise, but times and people change. You don’t want to end up in a bitter court battle because you pushed off creating an operating agreement.
It’s a document that will protect the rights and interests of your LLC members and ensure smooth, continued operations in the event of any unexpected hurdles or pitfalls.
Does an LLC operating agreement need to be notarized in California?
No, operating agreements do not have to be notarized. They are not filed with the state, just kept in your records. They are, however, required in California.
What happens if a California LLC does not have an operating agreement?
California default rules for LLCs will apply, but in cases of dispute, the law may be vague, and your members could end up in court. Since operating agreements are required in California, legal issues are more likely to occur in these cases if you don’t have one.