Understanding the Benefits of LLC Operating Agreements in Arizona Law

Limited liability companies (LLCs) have become the go-to business entity for entrepreneurs and business owners. The combination of limited liability protection and partnership-like relationships between the members makes the LLC entity an easy choice for many business ventures. In the whir of starting a new business, however, the members of some LLCs forego drafting and preparing an operating agreement.

Although not required by law, operating agreements are essential because they define the partnership relationship between the members, clarify the rights and responsibilities of members and managers, set up internal governance procedures, and establish the management structure for the LLC. Operating agreements can also include provisions such as the right of first purchase, valuation of membership interests, and procedures for dispute resolution, and other provisions. Because the operating agreement serves as a contract between the members, many problems can be avoided or minimized if an operating agreement is drafted and signed when the LLC is formed.

The advantages of LLC operating agreements make them an essential component for most, if not all, LLCs. This post presents a brief overview of the benefits of LLC operating agreements under Arizona law.

Legal Framework in Arizona

In Arizona, LLCs are governed by the Arizona Limited Liability Company Act. A.R.S. § 29-3101 - 4202 (Title 29, Chapter 7). Although not required, attorneys highly recommend the use of LLC operating agreements. If the members (and manager if there is one) have not signed an operating agreement, the rules set forth in the LLC statute will apply. As such, without a written operating agreement, the statutes will provide default rules that the members must follow if a dispute arises.

What Is an LLC Operating Agreement?

Under Arizona law, an operating agreement is an agreement between the members (owners) of the LLC that defines the rights and duties of the members and the agreed-upon rules for the governing the relationship between the members and procedures for management-level decisions. Some of the most-important provisions cover how profits and losses will be distributed and how key decisions will be made.

By statute, an operating agreement governs all of the following, although other terms and conditions can be incorporated into the agreement:

1. The relationship of the members to each other and to the LLC;

2. The rights and duties of the manager (if it is a manager-managed LLC);

3. The internal activities and affairs of the LLC and how they will be conducted;

4. How the operating agreement can be amended.

The operating agreement can revise or eliminate the fiduciary duties owed by members to the LLC, except for the obligation of good faith and fair dealing and the duty to refrain from willful or intentional misconduct. A.R.S. § 29-3105(C).

Many other agreements can be, and often are, included in written operating agreements. These may include provisions for buyouts, valuation of interests, rights of first purchase, assignments of membership interests, dispute resolution, and other provisions.

Benefits of an LLC Operating Agreement

Operating agreements provide several benefits:

1. Clarifies Ownership and Management Structure. An operating agreement will state the percentage of each member’s interest and the internal procedures for decision making and governance of the LLC. This clarity helps prevent disputes among members regarding their roles and responsibilities, ensuring that everyone understands their position within the company.

2. Defines Profit and Loss Distribution. Because most LLCs are for profit businesses, an important part of the agreement defines how profits and losses will be distributed. This is particularly important in multi-member LLCs, as it helps avoid misunderstandings and conflicts over financial matters.

3. Establishes Management Procedures. An operating agreement can outline the procedures for decision-making, including how meetings will be conducted, voting rights, and the process for admitting new members or handling the departure of existing ones. This fosters smooth, orderly, and efficient operation of the LLC.

4. Protects Limited Liability Status. Having a well-drafted operating agreement can help reinforce the limited liability status of the LLC. In the event of a lawsuit against the LLC, a court may look to the operating agreement (along with other evidence) to determine whether the LLC is being operated as a separate entity. This can help protect members' personal assets from business liabilities.

5. Facilitates Dispute Resolution. Unfortunately, disputes can arise between the members or between the members and the manager. If a disagreement arises, a dispute resolution mechanism will provide a procedure for attempting to resolve the dispute. This may include mediation or arbitration procedures, which can save time and money compared to litigation.

6. Enhances Credibility with Banks and Investors. Having a formal operating agreement can enhance the credibility of the LLC when seeking financing or attracting investors. The operating agreement shows that the business is organized and has procedures for internal governance and operation, which can instill confidence in third parties.

7. Customizable to Fit Unique Needs. An operating agreement can be tailored to meet the specific needs and goals of the members and the business, which allows the members to include provisions reflecting their intentions and business strategies.

Conclusion

Although not required under Arizona law, an operating agreement is an essential document that defines the relationship between the members and the LLC, establishes procedures for internal governance and management, describes the method for distribution of profits and losses, and states the duties and obligations owed between the members. By clearly defining these provisions, terms, and conditions, an operating agreement helps prevent disputes and reinforces the limited liability status of the LLC. Thus, investing time in drafting an operating agreement, or investing in an attorney’s time to draft one, is a wise decision that can promote long-term success and stability. James D. Griffith at Endurance Business Law, PLLC, is a business law attorney who can advise LLC members on forming an LLC and draft an operating agreement. To set up a paid consultation, please call our office at (480) 997-2951 or the Contact form on this website. If we establish an attorney-client relationship, the consultation fee will be deducted from the fees for our services.