Forming a limited liability company (LLC) in California can be an excellent way for small business owners to limit personal liability while maintaining flexibility in management and taxation. Unlike corporations, which are governed by more rigid statutory structures and corporate formalities, LLCs offer a more adaptable framework—particularly beneficial for small or closely held businesses.
One of the most critical documents for an LLC is the Operating Agreement, which governs the internal workings of the company. Under California Corporations Code § 17701.02(s), an operating agreement is defined broadly to include any agreement—oral, written, or implied—among the members concerning the affairs of the LLC and the conduct of its business.
One of the purposes of the LLC structure is to make things easier (compared to corporations) for people to operate businesses through. It is easy to forget though that something that is easier does not always mean it is better. The corporate formalities, like meetings, which corporations have to follow can be a good thing. It helps get major decisions memorialized in writing, etc. An operating agreement should be viewed not as a hassle or some template form, it is a way for people to set out how they want their entity to be operated.
No One-Size-Fits-All Operating Agreement
Too often, business owners turn to generic templates to draft their LLC’s operating agreement. While these can be a helpful starting point, they rarely reflect the specific needs and expectations of the business or its members. A well-drafted operating agreement should be tailored to the realities of your business and the relationships among the individuals involved. Failing to customize this agreement can lead to confusion, operational inefficiencies, and even costly disputes down the road.
Common Pitfalls in Template Operating Agreements
Here are a few examples of where standard forms often fall short:
- Buyout Valuation Methods That Don’t Make Sense: Some templates include a rigid and expensive process for valuing a member’s interest, such as requiring multiple professional appraisals. While thorough, this can create unnecessary expense and delay when members are trying to resolve a buyout or separation.
- Decision-Making Deadlocks: Many operating agreements default to requiring unanimous consent for major decisions. While this may seem equitable in theory, in practice it can become unworkable—especially when there are multiple members or managers. Without carefully tailored voting provisions, the business could be paralyzed by disagreement over relatively routine matters.
- Ambiguity Around Sweat Equity Contributions: It’s common for members to earn their ownership interest through “sweat equity”—their time, effort, and expertise rather than a cash contribution. However, problems arise when expectations around performance or contribution are not clearly spelled out. If a member underdelivers or if the other members had different assumptions about what was promised, disputes can quickly follow.
An Ounce of Prevention
Ultimately, an operating agreement should help prevent problems—not cause them. It should be a tool that clarifies roles, decision-making processes, financial arrangements, and exit strategies in a way that is practical and appropriate for the unique people and goals involved.
Working with legal counsel to draft or review an operating agreement ensures that it reflects your specific situation, avoids unnecessary pitfalls, and sets up the LLC for long-term success.
If you are starting an LLC or reviewing an operating agreement someone else has prepared, don’t settle for a boilerplate form. A few thoughtful provisions today can save you from costly conflicts and unnecessary misunderstandings tomorrow.