Operating Agreement Definition
The LLC Operating Agreement is a crucial document for any Limited Liability Company in Colorado or elsewhere. The Operating Agreement is an internal document that sets up the specific rules and guidelines that the LLC chooses to follow. Colorado law calls this document a "written operating agreement" in § 7-80-104(23) and most people refer to it as the Operating Agreement. However, you can also think of it as a "LLC Operating Agreement" since the agreement is for the owners (called the "members") of the LLC.
The LLC Operating Agreement essentially offers another layer of protection for the business . While the formation documents are public record, the LLC Operating Agreement is not on file with the Colorado Secretary of State.
Furthermore, the LLC Operating Agreement is a flexible document that allows the LLC to do things a bit difference than a standard LLC that does not have one. For example, Colorado law requires certain things to be included in an LLC Operating Agreement. See § 7-80-401 of the Colorado Revised Statutes. Furthermore, Colorado law permits the operating agreement to vary certain outcomes from state laws that would otherwise apply (but makes clear how such variations must be made). If there is no LLC Operating Agreement, the default provisions of Colorado law will apply.
Importance of Operating Agreements for Colorado LLCs
When it comes to legal protections, a limitation of personal liability is one of the most desired benefits. When establishing a new Colorado LLC, one of the biggest legal protections you can put in place is an operating agreement. The operating agreement outlines the ownership structure, ownership percentages, and managerial duties of individuals. The operating agreement provides operational continuity and cover rules that don’t necessarily apply by the state of Colorado.
Although Colorado’s LLC operating laws provide some protection, without an operating agreement in place, you won’t have much say about how the LLC is run. Colorado uses agency theory that allows managers and members the authority to bind the business. Any rules not covered by the operating agreement will be interpreted based on agency theory rules. Another protection an operating agreement offers is the ability to override the default laws that hold members personally liable for debts and obligations. If you do not follow the terms of your operating agreement, the court is more likely to disregard the protections for owners.
Because an operating agreement enables owners and managers to customize the rules, there is a greater degree of protection of those making managerial decisions. There are many elements that can override state rules in the legal document including: buy/sell rules, management structure, voting rights, membership and allocation of profits and losses. By having these elements in place in an operating agreement, managers have greater security for decision making.
Essential Components of a Colorado LLC Operating Agreement
When drafting an LLC operating agreement in the state of Colorado, there are several key components that must be included to ensure compliance with Colorado LLC laws and to protect the interests of all members of the business.
- Name of the LLC: The operating agreement should provide the official name of the business entity, which must be consistent with the name filed with the Colorado Secretary of State’s office.
- Formation Date: The agreement should also include the date on which the LLC as established, as well as any relevant filing dates or amendments that members consider to be important.
- Specify members: The names of all members and their roles in managing and operating the business should be included in the document.
- Define financial interests: All financial interests, including how profits, losses and capital will be allocated among members, should be clearly understood and outlined in the operating agreement.
- State duration of the business: This can be in terms of years or for the lifetime of the owners, depending on the preferences of members.
- Create policies for seasonal activities: If your business has periods of the year during which expansion is necessary or services are reduced, specify the need for additional funds from members.
- State minimum and/maximum investments: Members should clearly understand how much money each one must provide to the business. Many times the minimum investment is placed at a specific dollar amount ($10,000, for example). The maximum investment is either a specific amount or left open-ended (or at least open to discussion) so as to provide flexibility for funding in the future.
- Member withdrawal: State terms under which members can withdraw from the entity, including the cause for withdrawal, the sale of shares, etc. Without this clearly stated, each member carries an equal say in the business, even in cases where outside investors are not included as members.
- Choose governing authority: Members must also make clear whether they elect to have an LLC board or managers running the business.
- Define profit distribution: The operating agreement should also state how capital, profits and expenses are distributed among owners.
- State confidentiality requirements: If you want members required to retain business confidentiality, this requirement should be outlined clearly.
- Define process for amending the operating agreement: If owners need to change the agreement in the future regarding any aspect of operations that may require unanimous agreement, the amendment process should be laid out in detail.
These are some of the key items that must be included in an LLC operating agreement in Colorado, according to state law.
How to Complete an LLC Operating Agreement
Step 4: How to Draft an LLC Operating Agreement in Colorado
To draft an LLC Operating Agreement in Colorado, you start off the same way as you would with any other form of agreement-by explaining all the relevant points of law in a way that’s easy to read and understand. That said, there are a couple of specific things you will need to keep in mind in the context of a Colorado LLC.
First and foremost, the Colorado Limited Liability Act has a default operating agreement that all LLCs are subject to. It’s free of charge and is basically included in your operating agreement unless you specify that you do not want to follow the default rules of the Colorado Limited Liability Act. This default operating agreement in the Colorado Limited Liability Act (C.R.S. 7-80-501 to 504) includes general provisions for management, property ownership, capital contributions, distributions, transferees, indemnification, dissolution, etc. Essentially, this portion of the statute will act as the operating agreement (it’s considered a part of your operating agreement) in the absence of contrary terms in your written operating agreement. If you want to follow the default LLC rules of the Colorado Limited Liability Act, you can use a form operating agreement to simply ensure your operating agreement addresses all the provisions of the Colorado Limited Liability Act. However, to protect yourself as much as possible, you always want to draft a specific operating agreement that either tracks the Colorado Limited Liability Act specifically or addresses each subject separately. You can say you are adopting the Colorado Limited Liability Act general provisions without copying all the specific terms, but you still should not vary from the statute’s terms.
Things to think about as you draft an LLC operating agreement in Colorado:
Further Research:
If you want to get a full grasp on what you are doing and why you are doing it, the Colorado Secretary of State has provided a free booklet titled FAQs about Colorado LLCs on their website.
Sample LLC Operating Agreement
A typical operating agreement will include sections that detail the initial financial contributions of the members, define what actions require unanimous consent, how membership interests are assigned or transferred, the powers and duties of officers, provisions for personal liability protection, how voting is to take place, and the means by which to amend the operating agreement.
It may be helpful to begin by reading through a sample Colorado LLC operating agreement to get an idea of the kind of language typically used in these formal documents . Keep in mind, however, that you will need to edit any sample operating agreements you find to suit your specific business needs. A Colorado LLC in a single member format will not need the same provisions as one that has 5-6 members, in which one person will undoubtedly have control over the operation. Likewise, a business that is still in the pre-operational stage will have different needs than one that is a fully functioning enterprise with both employees and clients.
Errors in Formulating Operating Agreements
The process of creating an LLC Operating Agreement in Colorado can be fraught with common pitfalls and mistakes. Steering clear of these errors is incredibly important to ensuring that your LLC remains compliant and operates smoothly.
Custody of the operating agreement: One of the common mistakes in setting up an LLC relies exclusively on the need for this clause. Many operating agreements specify that all of the signatories will maintain original copies, and that a copy will remain with any financial institutions or other agencies related to the LLC. In reality, this is seldom the case. Instead, it is exceedingly difficult to track down or obtain a copy of the operating agreement after years have gone by. Instead, you should specifically name a custodian (an individual or a company) that will maintain a copy of the operating agreement. Underestimating or forgetting key provisions: Key provisions include definitions, regulations and amendments that help to direct the formation and regulation of the LLC. Furthermore, make sure that you have included references to relevant provisions outside of the operating agreement itself, such as: (1) name and type of limited liability company; (2) required actions to be taken if a member wishes to leave the company; (3) maintenance and custody of records; (4) restrictions on the transfer of membership interests; and (5) an article of dissolution. Excessive repetition: Many LLC operating agreements have sections that repeat key provisions several times. Not only does this look unprofessional, asking someone to sign a contract that is obviously filled with placeholders or unnecessary repetitions is a sure way to set a bad example for the company. It can also lead to agreement violations if a provision is overwritten or omitted. Failing to consider state conflict law: This is especially important in jurisdictions like Colorado where laws can be interpreted differently in adjacent jurisdictions. When dealing with disputes between an LLC and an outside entity, you could end up spending a lot of money in litigation if your operating agreement fails to list the home state of the LLC, and misidentifies another state as the location of the company’s business. Insufficient safeguards for liability provisions: Liability provisions, such as limiting liability from legal fees, should be very specific when dealing with a mixed-LLC, or an LLC organized in an investor-friendly jurisdiction. States like Delaware favor the protection of business confidentiality, but this can lead to large losses if an investor is privy to the deal and assumed to be a "professional" investor. Be specific in listing the types of damages that are covered, and whether the LLC itself is liable for those damages. Failure to identify financial considerations: Your operating agreement should clearly outline the financial considerations of each member, including the process for distributing profits/losses, as well as the method for determining each member’s share of those profits/losses. Being too vague: Make sure that any provisions or references outside of the agreement are clearly enumerated. Failure to do so often leads to lack of clarity in instances of future dispute. Inadequate provisions for member and management: It’s not uncommon to lump language together to deal with provisions that apply to members and managers in the same fashion. This is a mistake. The language for member and management provisions should be clearly distinct. Leaving out a due diligence clause: Just as with the custodian clause listed above, your LLC operating agreement should clearly define who has the right to inspect books and records related to the company, as well as a process for doing so, including a timeline and proof of identity. If you review these common mistakes and ensure that they are not included in your LLC operating agreement, you should be headed in the right direction.
Reviewing and Modifying the Agreement
A crucial aspect of maintaining the integrity of an LLC is the periodic review and revision of its operating agreement. As your business evolves, it is essential to make sure that the terms governing your LLC remain relevant and reflective of any changes in the management structure or business operations.
Reviewing the operating agreement should involve evaluating whether the management structure is still suitable for the current business model. Perhaps the original LLC members have brought on new skilled partners who wish to have a bigger role in the management of the company, but the existing agreement is too rigid to accommodate these desired changes. Alternatively, members may have become too busy running day-to-day business operations, and may prefer to step back from the internal workings of the company and have an external manager run the business. Other key components of the operating agreement include how profits are distributed, how disputes are handled, how new members may join, the process for exiting members, and what type of voting system is in place. Even just one of these factors may dictate a big change in how a company does business if it is not carefully reviewed and considered. As your business needs change, your LLC operating agreement should be carefully reviewed and revised to address any modifications. Regular review of the operating agreement is also important for protecting the interest of LLC members. For example, if an LLC member were to take out a personal loan and use their financial interest in the company as collateral, the lender would assume the risk for this loan. If the operating agreement does not explicitly indicate the process for collateralizing LLC interests, the lender may try to seize a part of the business interest in the event of default. Revisions to the operating agreement will make sure that all interests are protected, and will avoid costly disputes in the future.
Legal Help and Resources
The creation of an LLC operating agreement is a fundamental step in ensuring a well-functioning business organization, yet it can also be a complex and nuanced task. The value of legal consultation during this process can’t be understated. An experienced business attorney in Colorado can provide invaluable insight into the intricacies of LLC law, hydrocarbon industry-specific regulations, and the best practices for your operating agreement that are tailored to your particular business needs. This professional assessment can save you time, money, and headaches by ensuring that your essential documents meet all legal requirements and protect the rights of all parties involved.
In addition to professional legal services, there are a variety of resources available to Colorado LLC owners for creating a robust operating agreement. The Colorado Secretary of State’s website offers an array of helpful forms and information on maintaining and forming your LLC, including topics such as company name registration, filing annual reports, and the general requirements of LLC formation in Colorado. Legal books, online legal platforms, and DIY templates may also be utilized to create an operating agreement, however , these tools may lack the nuance and customization that a tailored operating agreement can offer.
For a DIY approach, there are numerous online flexibility agreements for Colorado LLCs available for download. Unfortunately, these documents are often generic and not designed specifically for Colorado LLCs, meaning they may lack the necessary specificities otherwise covered in a customized operating agreement. For example, note that the statutes that cover amending an LLC operating agreement (Colorado Revised Statutes §7-80-108) do not even contain language that refers to articles of organization or formation, so whereas many LLCs may refer to articles of formation in their operating agreement when amending the operating agreement, that language is technically incorrect. Using the generic provisions of these online operating agreements could cause greater issues down the road, which is precisely what a strong operating agreement seeks to avoid.
Whether you decide to use an existing operating agreement template or create a customized one with legal consultation, having an operating agreement is essential for the long-term success and maintenance of your LLC. Make sure to seek out all of the resources, both human and electronic, that Colorado has to offer for both ongoing assistance and information.