What is an Operating Agreement?

November 6, 2020
Business Basics
What is an Operating Agreement?

When embarking on a new business venture or choosing to adapt your current business structure by forming a limited liability company (LLC), you must have all the necessary paperwork (like an operating agreement) in order. Filing Articles of Organization with the proper state authorities is required for legal operation as an LLC. This document establishes the rights, powers, duties, liabilities, and obligations for each member of the LLC as well as those between the LLC and each of its members. An Operating Agreement, on the other hand, does not have a mandatory filing requirement but some states (e.g., California, Delaware, Maine, Missouri, and New York) require that one is created and kept on record. So, what exactly is an Operating Agreement, why do you need one, and what is required to create one?To help you navigate the formation of your LLC, we’ve put together this quick and easy guide to Operating Agreements!

What is an Operating Agreement?

An Operating Agreement is a document that lays out the rules and guidelines for operation based on the specific needs of each member. Once signed by all members of the LLC, the Operating Agreement, or “Members’ Agreement,”  is a binding document that lays out the rules for day-to-day business operations. LLCs can specify and clarify operating rules and management of the business.

Why You Should Have an Operating Agreement

While it may not be necessary to file an Operating Agreement for your LLC, failure to create this document can leave you and the members of your LLC quite vulnerable. Putting an Operating Agreement in place can:

  • Help protect the status of your LLC. An Operating Agreement can protect each member from personal liability. Without this document in place, your LLC will be viewed as similar to a partnership or sole-proprietorship and personal liability could become an issue if a dispute arises.
  • Clarify agreements between members. Even if all of the members have verbally agreed to a particular business set up, miscommunications and disagreements can happen. When signed by all members for the LLC, an Operating Agreement becomes a legally binding document and all members will be required to abide by the conditions laid out in it.
  • Protect your agreements at the state level. Without an Operating Agreement, the rules of your LLC default to the state rules. These rules are very general and are not a great basis for managing your operations. Additionally, if you are operating your business in multiple states, then the agreements will vary based on their location of operation. Operating Agreements will synchronize your business between these varying regulations.

So, while it isn’t necessary to file an Operating Agreement with the state, it is advisable to create one to protect your LLC on the state level, to clarify misunderstandings internally and for legal reasons, and to promote business conduct that is agreed upon by the LLC owners and members.

What Should Be Included in an Operating Agreement for an LLC

An Operating Agreement is not a one size fits all document. You may need to adjust the contents to suit your LLC and your chosen course of operations, but here is a closer look at what should be included in an Operating Agreement.

Basic Information

Membership Information

In this section of the Operating Agreement, you will layout how members can join the LLC, their contributions, their capital, and how profits and losses are to be divided. Include:

  • Names of initial members
  • The amount of their contribution
  • Ownership percentages
  • How new members make initial contributions and the required amounts
  • The process for admitting new members
  • How members receive profits and losses each year
  • How taxes are allocated and distributed on profits and losses

Management of the LLC

In this section, you will include important information about the management of the LLC. To begin, you will need to decide if your LLC will be managed by one of the members or if you will hire a manager that works as an employee of the LLC. Unless the LLC is very small, it is best to designate a single person to act as the manager. This section will also include information about the decision making process. Will decisions be made by a majority vote or must they be a unanimous decision? These are important things to decide before you get deep into your operations.

Provisions for Leaving or Ending the LLC

In this section, you will want to cover what happens when a member leaves, the business reaches its termination date, or the processes for ending the business. It should include:

  • When and how a member can leave the LLC
  • How a member can be asked to leave the LLC
  • The process for buying back a member’s interest (including how the price is determined and paid)
  • The process for transferring a member’s interest (including restrictions on transfers)
  • Liquidation procedures and distribution of member property

Liability Clause

Include an indemnification or liability clause in your operating agreement. This will ensure that all members have limited liability for their actions as members of the LLC.

Special Agreements

Again, depending on the nature and scope of your LLC, it may be necessary to include additional sections in your Operating Agreement. These sections might include:

  • Processes for how to amend the agreement
  • How notices should be communicated
  • A non-compete agreement: restricting members from joining competing businesses
  • A conflict of interest policy
  • A non-disclosure agreement
  • Record-Keeping Requirements: each state will have its own record-keeping requirements. It is also a good idea to check with the IRS for the types of records you should be keeping.

Drafting an Operating Agreement

It is possible to find online templates for an Operating Agreement but it is important to consider all of the above information, the specific needs of your LLC, and the needs of all the members before completing this document. You may also need to change and re-file your Operating Agreement if you filed a Doing Business As (DBA) or fictitious business name. Remember, what is right for one business may not be right for you. If you have any doubts about what you need to include, consult a lawyer or registered agent for guidance. It is best to create an Operating Agreement when initially forming your LLC but if you are already well passed that stage, it is not too late. It is never too late to create this document as long as every member of the LLC agrees to its contents. If you already have an Operating Agreement and wish to change it, you can do so by consulting an attorney and following any provisions laid out in the original document.

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