What is an operating agreement for an LLC?

What is an operating agreement?

An operating agreement is a legal document that provides the foundation for your limited liability company (LLC), and sets out how it will operate.

An operating agreement outlines the structure, management, and decision-making process for an LLC. It serves as a contract that binds the LLC’s members (owners) to its terms.

The agreement is created during the setup process of an LLC and plays an important role in defining how an LLC is organized and governed, and how it conducts its business activities. It outlines the rules for how the LLC will operate to prevent misunderstandings or conflicts among its members.

An LLC operating agreement is an internal document, unlike the articles of organization that must be filed with the state to create the LLC.

Do you need an operating agreement for your LLC?

Operating agreements aren’t legally required in most states when setting up your LLC. Right now, only five states (California, Delaware, Maine, Missouri, and New York) require an operating agreement.

Why an operating agreement is a good thing to have

Every LLC should have an operating agreement in place to protect its members, even if it’s not a legal requirement. Without one, your LLC is subject to the default rules set out in your state’s LLC laws, which are basic rules that cover things like company structure, voting rights, and profit allocation. These rules might not suit how you want to operate your LLC and could leave it vulnerable to unintended consequences.

For example, let’s say you form an LLC, but you don’t establish an operating agreement that requires all partners’ consent before any one partner sells their interest in the LLC. Since the state doesn’t restrict transfers or sales, a partner could sell their interest, even if other members don’t want this to happen.

Most states’ default rules also require profits to be divided equally among owners unless otherwise stipulated. Without an operating agreement, an owner with a significantly larger investment may not be legally entitled to their proportional share of the profits.

Other risks of not having an LLC operating agreement include:

• potential for misunderstandings or disputes among members due to a lack of clarity
• lack of freedom in structuring management, ownership, and financial arrangements
• vulnerability to the default rules changing in your state

On the other hand, an operating agreement enables LLCs to:

• tailor rules to their business needs and preferences
• clarify ownership interests, rights, responsibilities, and obligations
• detail procedures and processes for the transfer or sale of interests, dissolution of the company, or for adding members

Accounting software like Xero can give members clarity around the financial status of the LLC and their equity in it.

What to include in an LLC operating agreement

You should always seek legal guidance to ensure you’re following the proper steps and complying with applicable laws when creating your operating agreement. A legal advisor can also help you structure it for your LLC’s specific needs.

Here’s some of the basic information that is typically included in an LLC operating agreement.

Company information

Operating agreements should include basic company information, such as the:

• name of the LLC
• purpose and nature of the business
• business’s registered office and agent

Member details

You should also list the names and contact information for members, their initial capital contributions, and ownership or member interests.

Management structure

Most states’ default rules include member management provisions, which generally mean each member can act independently on behalf of the LLC.

Instead, an operating agreement could authorize only specific people, like a manager or particular members, to take action on the LLC’s behalf. For example, a manager-managed LLC agreement designates an individual – such as a member, an outside manager, or a management company – to run the LLC.

Either way, the operating agreement makes it clear who can do what and who can’t.

Operating procedures and voting rights

Your agreement should explain how you’ll make decisions. In most states, the default is to split voting power in LLCs according to ownership percentages. You might want to do it differently – for example, you might require a majority vote of members, or even a unanimous agreement.

A common approach is to assign operational decisions to a member or manager while requiring major decisions, such as signing contracts or acquisitions, to be put to a vote.

Financial information

An operating agreement can give your LLC the flexibility to distribute profits and ownership interests in different ways.

Many LLCs choose to assign proportions of ownership based on the amount of funds members have invested in the business. Others assign ownership interests and profits based on the revenue generated by each. For example, a group of architects forming an LLC might agree to share profits based on the amount of business each individual brings in, rather than on their ownership interest.

Other provisions may address:

• who takes responsibility for preparing, reviewing and filing taxes
• tax years and accounting methods
• bank accounts and who has access to them

Buyout provisions

An operating agreement should specify what happens when someone wants to sell or exit the LLC. A common provision is to require any member who voluntarily leaves the LLC to offer their interest to other members before offering it to an outside party.

Dissolution provisions

You should also define how assets and any profits or losses will be divided if you decide to dissolve the LLC.

Liability statement

Without an operating agreement, members may not be shielded from liability – even under an LLC structure. The agreement should set out how members won’t be held personally liable for expenses, debts, obligations, or claims.

Keep in mind that you can’t abdicate all liability. In the case of unlawful activity or wrongful acts, a member can still be held personally liable.

Dispute resolution

When you’re starting a business, you won’t be thinking about what happens if there are disagreements or if something goes wrong. But you should always include mechanisms for resolving disputes.

For example, you may want to require members to deal with disputes internally before taking legal action, and perhaps to stipulate that if disputes can’t be resolved internally they go to mandatory arbitration rather than to court.

Can an operating agreement be changed?

Yes, operating agreements can be changed. Any member can suggest a change, but all members will need to agree – by a majority or a unanimous consent, depending on your voting rules.

It’s a good idea to spell out the process for changes within the operating agreement itself.