Why Every Pennsylvania LLC Needs an Operating Agreement

When it comes to small businesses, we often only hear about the success stories. But as a small business attorney, I frequently receive calls from those on the opposite end of the spectrum — folks whose entrepreneurial dreams have turned into nightmares. And in most cases, the issues they’re facing are the result of simple mistakes that could have been easily avoided. One such mistake that I’ve seen cause issues for small businesses in Philadelphia is the lack of a written operating agreement.

• • What is an operating agreement?
  • Why is it important?
  • What are the risks of not having one?
  • What are some key provisions to include in my operating agreement?

I wrote this blog to help you these questions and more. 

But before you dive in, don’t forget to download our free operating agreement checklist! This helpful tool provides an expansive list of the provisions that every entrepreneur should consider including in their operating agreement. 

And if you’re just learning the basics about LLCs, check out our LLC FAQ page where we provide answers to common questions about limited liability companies.

What is an Operating Agreement?

An operating agreement is a contract between the members of an LLC that outlines how the company will operate. This foundational document outlines:

• • Who the members are, and their rights and responsibilities to one another and the company.
  • Who has decision-making authority—whether it’s the members (in a member-managed LLC) or a designated group of managers (in a manager-managed LLC). It also specifies the limits of that authority. For example, if certain decisions require a majority or unanimous agreement of the members.
  • What members are required to contribute to the company in exchange for their ownership interest.
  • When profits may be distributed to members, and who gets to make that decision.
  • The circumstances under which a member may be added or removed from the company.
  • What should happen if one of the members or managers passes away or is otherwise unable to perform their responsibilities.

 

What if I Don’t Create an Operating Agreement for My Pennsylvania LLC?

If you don’t create an operating agreement for your Pennsylvania LLC, state law sets the rules for how your business must operate. In effect, Pennsylvania law becomes your operating agreement. This means every LLC technically has an operating agreement, even if the members haven’t created one themselves.

However, as a business owner, it’s crucial to create an operating agreement tailored to your business. Here’s why.

Unexpected Consequences

Most business owners don’t have the time to read the entire Pennsylvania Uniform Limited Liability Company Act. They aren’t aware of how the law impacts their rights and responsibilities as LLC owners. As a result, they may run into problems they never anticipated.

For example, in Pennsylvania, one member of an LLC can sign a contract that binds the entire company—without the approval or even the knowledge of the other members. I’ve seen situations where one member in a multi-member LLC took out a loan in the name of the company without telling their business partners. Years later, when the member who took the loan stopped paying it back, the loan company came after the LLC. And guess what? The LLC had to pay!

Drafting your own operating agreement allows you to set your own rules and avoid situations like these.

Partnership Disputes

No matter how great your relationship with your business partner is, disagreements are inevitable. If you haven’t worked out a process for resolving those disagreements, they could lead to the breakup of your business. This is especially common in 50/50 partnerships.

In a 50/50 partnership, any decision requiring a majority vote actually requires a unanimous vote. Without an operating agreement with a tie-breaker provision, 50/50 partners could easily end up stuck in a stalemate.

When the issue is small, you may be able to compromise. But what if it’s a critical issue? For example, what if one partner wants to sell the business and the other doesn’t? In situations like these, partners often end up in court. But all this drama can be avoided with a written operating agreement.

Missed Opportunities

Generally speaking, your operating agreement is an internal document that won’t be shared with outsiders. However, there are situations where you’ll need to share it with a third party to work with them.

For example, banks typically require a copy of your LLC operating agreement in PA when you open a business checking account. They need to see who is entitled to access the account and make decisions on behalf of the business.

Similarly, if you’re applying for a loan, the financial institution will want a copy of your operating agreement. Without it, they’re unlikely to even consider lending to you.

And for businesses interested in getting certified (e.g., WOSB, MBE, etc.), the certifying agency will need a copy of your operating agreement in order to verify

1. 1. who has an ownership interest in the business; and
   2. who has control.

As you can see, not having a written operating agreement can prevent you from accessing opportunities that would otherwise be available.

Critical Pennsylvania Operating Agreement Provisions

Clearly, it’s important to have a written operating agreement that fits your Pennsylvania LLC. But what terms should you actually include in your operating agreement?

The answer to this question is different for every business. And if you need help drafting something that fits your business’s unique circumstances, MZA Legal can help.

But while you’re reading, here are some key terms that every entrepreneur should pay attention to when putting together an operating agreement for their PA limited liability company.

Contributions

Every operating agreement should address contributions. A contribution (in this context) is whatever a member provides to the company in exchange for their membership interest. Typically, members invest money into the business as their initial contribution. However, they may contribute anything of value, including real estate, intellectual property, or their time and energy working for the business.

Your operating agreement should not only spell out the initial contributions of each business owner but also address whether they’ll be required to make additional contributions in the future. If so, under what circumstances would that requirement kick in? And if not, how will the company raise additional funding if necessary?

Distributions

On the flip side, every operating agreement should also cover the distribution of profits. This is a key topic because people are investing their time, treasure, and talent into the business—and they expect a return on their investment. If everyone isn’t on the same page about when that return will come, it could lead to disputes.

Even for solopreneurs, it’s a good idea to outline when you will take profits. The number one way LLC owners lose the liability protection their LLC gives them is by treating business funds as if they’re personal funds. Outlining a method for profit distributions will help you avoid the appearance of impropriety and encourage proper financial management.

Death or Incapacity

Death is the only guarantee in life. Despite this, few entrepreneurs are prepared for the inevitable. As a business owner, it’s critical to have a succession plan in place to ensure things can continue to operate smoothly if something happens to you. Your operating agreement plays a key role in this process.

In a multi-member LLC, the operating agreement is a place to specify what should happen to a deceased member’s share in the business. You may enjoy working with your business partner, but that doesn’t mean you’d want to work with their spouse, child, or next of kin if something happened to them. Many business partners include a buy-sell agreement, funded by life insurance, in their operating agreements. This ensures that the deceased member’s family receives the value of their hard work without forcing you to accept a new business partner.

In a single-member LLC, the operating agreement is a great place to specify:

• • How you want to pass the business along (e.g., refer to your will, trust, etc.)
  • Who should manage your business until it can be sold or transferred via your estate plan.
    
    

Removal of Members

If you have a multi-member LLC, it’s important for your operating agreement to address the removal of members, especially if each member is expected to play an active role in the business.

What often happens in these situations is some members pull their weight, while others just enjoy the ride. This creates resentment because even though some members aren’t contributing, they’re still entitled to a share of the benefits. Your operating agreement can serve as a method for holding deadbeat business partners accountable by giving you the option to remove them from the business under certain circumstances.

Often, the threat of removal is enough to keep everyone engaged. However, it’s important that a provision like this be drafted precisely by someone with significant experience. If it’s not, you could end up with a long, drawn-out court battle.

Management

Finally, the most important issue for an operating agreement to address is management and control. One of the benefits of having an LLC is that you get to choose who has management control over the business.

In a member-managed LLC, the members have the right to operate the business. Here, it’s important to specify each member’s roles and responsibilities to ensure effective management and avoid disputes.

In a manager-managed LLC, one or more individuals are appointed to operate the business. These managers may be members of the company or outside professionals. In either case, the operating agreement should define their roles, compensation (if applicable), and the circumstances under which they may be replaced.

Whether the company is member- or manager-managed, the operating agreement should also specify which decisions require special decision-making processes. For example, if certain decisions require unanimous consent, that should be stated in the operating agreement.

Bottom Line…

An operating agreement tailored to your business ensures you’re in control and ready for whatever comes your way. And every Pennsylvania LLC should have one.

If you still don’t have an operating agreement, why not save your time and energy by hiring a professional to draft your operating agreement for you? At MZA Legal, we’ve provided hundreds of entrepreneurs with guidance on the ins and outs of developing an operating agreement. Give us a call, or schedule a time to speak with one of our attorneys to learn more.