The Importance of Operating Agreements for LLCs in Minnesota

One of the most common forms of business that new owners use in Minnesota is a Limited Liability Companies (LLC). The choice is often between an LLC and a Corporation, with the LLC being preferred by many because it's one of the easiest to set up. The filings with the Minnesota Secretary of State are not as overwhelming as many people think they will be. Once you've taken that first step to getting your business formed, you also need to pay attention to the other key documents your business needs.

When it comes to an LLC, putting an Operating Agreement into place is a crucial step that many business owners, especially owners of single-member LLCs, seem to overlook. It's not a required document like an EIN or a license that is required to operate the business. In fact, Minnesota doesn't require that you have an Operating Agreement (some states require them to be signed within a certain period of time after the LLC is formed). But without one in place, you can end up in court trying to sort out even a basic disagreement between members of the business. And down the road, if you're looking to bring on investors or sell your business, they will want to see an Operating Agreement before they close the transaction.

What Is an Operating Agreement?

An operating agreement is a legal document that outlines the procedures, structure and general corporate operations of your LLC. It's an internal document that lays out a plan for how the business will be managed, how profits and losses will be distributed, and how major business decisions will be made. Essentially, it acts as the LLC’s foundational document, similar to corporate bylaws for a corporation or a partnership agreement for a partnership.

Your Operating Agreement is not required, but if you don't have one, then the Minnesota laws relating to LLCs will be your "default" agreement that governs how your business operates. Be careful though, because these default provisions may not always align with the specific needs and goals of your business, making a customized operating agreement a valuable tool for your LLC.

What's In Your Operating Agreement

Your Operating Agreement should have a variety of components, but it's not limited to just these seven areas. It's important for your agreement to be tailored to the actual needs of your LLC, so if you have other provisions that you need to include, you should be sure to review them with your attorney to see where they can fit in. The seven common components that my clients rely upon:

Ownership Structure – Your agreement outlines the ownership percentages of each member, their capital contributions, and the process for transferring ownership interests.
Management and Decision-Making – The agreement should specify whether the LLC will be member-managed or manager-managed, detailing the roles and responsibilities of each party.
Profit and Loss Allocation – This provision defines how profits and losses will be distributed among members, which may not necessarily be based on ownership percentages.
Voting Rights and Decision-Making Processes – You should establish voting rights, quorum requirements, and decision-making procedures to prevent disputes.
Member Responsibilities and Obligations – This section clarifies each member’s duties, contributions, and involvement in the business.
Dispute Resolution Mechanisms – An operating agreement should include provisions for resolving conflicts among members, including mediation or arbitration clauses. Before you choose, it's important to understand the different ways that mediation and arbitration can resolve your disputes (and the respective cost burdens of each).
Exit Strategies and Dissolution – The agreement should address what happens if a member wishes to leave the LLC or if the business needs to dissolve.

Why You Need an Operating Agreement for Minnesota LLCs

I've alluded to it before, but even though an operating agreement is not legally required in Minnesota, it provides several benefits that can help protect you as a business owner.

1. Clarity of Business Operations and Reduction of Misunderstandings

Without a formal agreement, members may have different expectations regarding management, financial distributions, and responsibilities. An operating agreement sets clear guidelines and expectations, reducing the likelihood of internal disputes. Without it, you can end up in lengthy and costly lawsuits over these misunderstandings.

2. Solidifying Your Liability Protection

One of the main advantages of forming an LLC is the limited liability protection it offers to its owners. Your operating agreement reinforces the LLC’s separate legal identity, helping to safeguard members’ personal assets from business liabilities.

3. Provides Customization Beyond Default Minnesota Laws

State default rules may not always align with the specific needs of an LLC. A well-drafted operating agreement allows business owners to customize their governance structure, decision-making processes, and financial arrangements to better suit their business model.

4. Helps Prevent and Resolve Disputes

Business disagreements are inevitable, especially in multi-member LLCs. A clearly defined dispute resolution process in the operating agreement can prevent costly litigation and provide a framework for resolving conflicts amicably.

5. Facilitates Business Continuity and Succession Planning

An operating agreement can specify what happens in the event of a member’s departure, death, or incapacity. This ensures a smoother transition and minimizes disruption to business operations.

What if You Don't Have an Operating Agreement?

Failing to create an operating agreement can lead to various complications, including:

State-Imposed Default Rules – Without an agreement, Minnesota’s default LLC laws will govern the business, which may not align with your preferences.
Increased Risk of Disputes – Ambiguity in roles, responsibilities, and financial arrangements can lead to conflicts among members.
Difficulty in Attracting Investors – Potential investors and lenders often prefer businesses with formalized agreements that outline management structure and financial protocols.
Challenges in Legal Protection – Courts may question the legitimacy of an LLC if there is no operating agreement distinguishing it from an informal business arrangement.

How to Draft an Effective Operating Agreement

When it comes time to put the Operating Agreement together, there are five common steps that my clients commonly use to get the document in place:

Identify Business Needs and Objectives – Define the LLC’s goals, management structure, and financial arrangements.
Work With Your Business Attorney – While you can find a website to mail-merge your information into its templates, working with an attorney ensures the agreement complies with Minnesota law and addresses specific business needs.
Include Essential Provisions – Ensure the agreement covers ownership structure, decision-making processes, financial distributions, dispute resolution, and succession planning.
Member Review and Agreement – All members should review and agree to the terms before signing.
Keep It Updated – As the business evolves, periodically review and update the agreement to reflect changes in ownership, management, or financial arrangements.

Do I Need a Business Attorney?

If you're just getting your LLC started, or if you've been running it for years and haven't created an Operating Agreement (or have one that needs to be updated), let's schedule a Legal Strategy Session online or by calling my Edina, Minnesota office at (612) 294-6982 or my New York City office at (646) 847-3560. My office will be happy to find a convenient time for us to have a phone call to review the best options and next steps for you and your business.