What is LLC Operating Agreement? An LLC operating agreement is a document written to define how an LLC will be run. It is a legal contract that is agreed upon and signed by the company owners. The agreement clarifies all the important details on how the company will be structured, run, and managed.
WHAT IS OPERATING AGREEMENT FOR LLC?
An operating agreement is written to document how an LLC company will be run. It allows the company owners to agree on a management and operational structure that works best for them and the company.
Once an agreement is reached the document is signed by all owners and becomes a binding set of rules by which to run the LLC. Although the document is not legally required in most states it is highly recommended you create one from the very outset of forming your LLC.
There are many benefits associated with creating an operating agreement and it will greatly assist the smooth running of your company.
OPERATING AGREEMENT GUIDE
- IS AN OPERATING AGREEMENT A LEGAL REQUIREMENT?
- WHY YOU NEED ONE
- HOW DO THEY WORK?
- WHAT ARE THE BENEFITS?
- WHAT’S IN AN OPERATING AGREEMENT?
- WHAT HAPPENS IF YOU DON’T HAVE ONE?
IS AN OPERATING AGREEMENT A LEGAL REQUIREMENT?
Are LLCs required to have an operating agreement? Although it is highly recommended that you create an operating agreement there are only six states that legally require one. These are California, New York, Delaware, Maine, Missouri, and Nebraska.
However, we recommend that all LLC businesses create an operating agreement. Many benefits come with writing one and no significant downsides – other than the time it takes to create the document. If no operating agreement exists, the LLC will be handheld as per your state’s default LLC rules.
An operating agreement sets down in black and white how the company will be run. It provides clarity to the objectives of the company and defines the roles and responsibilities of its members. Having this level of clarity helps avoid disputes down the road.
The document can also help uphold the limited liability status of the company. This is crucial if the company is ever taken to court and you want to protect your personal assets. Let’s take a closer look at all the benefits.
WHY DO YOU NEED ONE?
You need an operating agreement to provide clarity on all aspects of how your LLC will be managed, who the owners are, how profits will be distributed, and more. Creating an operating agreement and having all members sign up to it from the start establishes clarity and consensus on the important general matters of how your LLC will be operated.
In the absence of an operating agreement, an LLC will be run according to the default laws of the state you are in. This means the company members cannot control the company as they see fit and must follow state rules.
State laws are rarely a good fit for any business as they are designed as a general catch-all for all LLC companies. For example, state law may dictate that company profits are distributed equally among members regardless of the level of investment each member has made in the company.
However, there are many benefits to creating an operating agreement – read more below Benefits of an Operating Agreement.
HOW DO THEY WORK?
An LLC operating agreement is a legal contract that governs the running of an LLC company. The document is created from the outset when the LLC is first formed and agreed upon by all company members.
An operating agreement provides clarity on how the business will be run and will help avoid conflict between members when situations arise. It is a legally binding document and can be used as a tool for resolution when there is a disagreement.
BENEFITS OF AN LLC OPERATING AGREEMENT
What are the benefits of an LLC Operating Agreement? Now that we know ‘what is LLC operating agreement’ let’s take a look at the advantages of creating one. There are five key benefits, see below.
The existence of an operating agreement will help protect your LLC status by bolstering the legal boundary that exists between the company and its owners. An LLC is recognized as a separate legal entity and an operating agreement helps establish this independence.
If you want to protect the limited liability status of your company, then you must create an operating agreement. This will stand to you if the company is ever taken to court by its creditors or legal claimants. It will help protect your personal assets from legal claims.
DEFINE MEMBER ROLES
An operating agreement clearly defines the roles and responsibilities of its members. It documents the precise nature of each individual’s expected contributions. And, it should set out very clearly how profits will be distributed.
A clear definition of these details from the outset will help the business run smoothly and avoid conflict in the years ahead. If a conflict occurs, the document can be used as a resolution tool as each person’s role has been clearly defined.
Another benefit of creating an LLC operating agreement is that it codifies the governance rules of the company. Specifically, it documents the voting rights of its members and the rules on how company meetings should be run.
If you do not create an operating agreement to define how your company shall be governed the default rules for the state you are registered in will take effect. This means the manner in which the company will be governed is outside your control. If you want to avoid the LLC governance laws of your state, you must create an operating agreement.
DISTRIBUTION OF PROFITS
An LLC operating agreement defines how company profits will be distributed amongst its owners. LLC owners are also referred to as members. The LLC company structure allows for a flexible division of profits unlike other structures such as a C-corporation. But the manner of distribution needs to be clearly defined in the operating agreement.
In a C-corporation, the profits of a company are distributed amongst its shareholders. And the amount of money received by each shareholder is directly proportional to the share they hold. For example, if a shareholder owns 50% of the company, they will receive 50% of the profits.
In an LLC the operating agreement defines how profits will be distributed – not the number of shares held by any one member. This means members can be rewarded for the hours they spend running the company, or the value they add – and not just the capital they invest.
RULES OF SUCCESSION
An LLC operating agreement is a great way to define the rules of succession for the company owners. Succession refers to how someone is replaced when they finally leave the business.
Whether an owner passes away or they just want to retire from the company – the rules of succession should be codified in your LLC operating agreement. Clearly defining how retiring members will be succeeded by new members will help prevent costly legal battles and bitter family feuds down the road.
WHAT DOES AN OPERATING AGREEMENT LOOK LIKE?
An operating looks like a contract or legal agreement. The document is typically between five and twenty pages long. The exact contents and appearance of an LLC operating agreement varies greatly from one company to the next – so there is no one size fits all. However, several areas need to be covered, let’s take a closer look at these sections below.
WHAT’S COVERED BY AN OPERATING AGREEMENT?
What sections need to be included in an operating agreement? There are a number of areas that need to be defined and issues that need to be addressed. And, these will change depending on the nature of your business and the industry you operate in.
However, the key sections that need to be addressed by any operating agreement are Organization Structure, Management, Voting Rights, Member Contributions, Distribution of Profits, Changes to Membership, and Company Dissolution – see below.
The first thing that needs to be defined in your operating agreement is your business profile. This section will contain all the basic information about your LLC including – the company name, address, name and address of your registered agent, and fictitious business name or ‘trading as name’.
PURPOSE OF BUSINESS
This section defines the business purpose of the company. Typically this is a short component and a few sentences will do the job. You can use this section to clarify the product or service the company is offering and the industry it will operate in.
STATEMENT OF INTENT
The statement of intent documents that you intend to run the business in a manner that abides by your local state laws. And, that you will file and maintain all the necessary required documents to keep the company on the right side of the law.
DURATION OF BUSINESS
The duration of business section includes a statement to the effect that you plan to operate the business in perpetuity. The exception to this is companies that are formed with a plan to operate for a fixed period – for example, a joint venture.
By default LLCs benefit from pass-through taxation. This means company profits are passed through to its members without being taxed. Each individual then pays tax on this income at a personal level.
However, some LLCs are run as S-corps or C-corps by filing forms with the IRS. Whatever taxation regime you intend to run the company under – it needs to be defined here.
MEMBER & MANAGER DETAILS
This section records details of all the company members and managers. Note, in an LLC company an owner is referred to as a member. Information that needs to be recorded here includes – names, addresses, job titles, responsibilities, and ownership percentages for company members.
This section clearly defines how much each member has contributed to the company. Contributions are not just limited to financial investments and can include industry advice, professional skills, labor, intellectual property, and other contributions.
MEMBER/MANAGER ROLES, POWERS & DUTIES
Here you will define the powers and duties of all the members and managers. For example, one member may be assigned as the public relations manager and have the final say on all matters relating to company public affairs.
Any meeting rules or schedules that the company plans to operate by need to be tied down in here. An LLC company isn’t legally obliged to hold meetings for its shareholders and directors in the same way as a corporation. So, if you intend to define a company meeting structure it needs to be captured in the operating agreement.
Voting rights need to be clearly defined and they must be established right from the outset. Any important business that requires a vote at a company meeting will be governed by these voting rules. The voting share for each member needs to be documented so votes can be taken and a clear course of action decided open quickly.
PROFIT & LOSS DISTRIBUTION
This section will detail what percentage of the company profits each member is entitled to. Profit distribution is not always directly proportional to the level of capital investment each member has invested in the company. Some members may be rewarded for the hours they spend running the company, providing professional advice, or other skills and resources.
NEW MEMBERS, SUCCESSION, BUY-OUT RULES
This section codifies all the rules for the addition of new members to the company, succession rules, and how a buy-out of an existing member should proceed. This will allow things to run smoothly if a member wishes to retire or cash in on their share of the business.
Dissolution refers to the dissolving of the business. This happens if the members decide it is in their interest to wind down the company. This section will provide the rules agreed open on how to proceed through the dissolution process.
Dissolution can be a complicated process, so agreeing on some rules from the outset will allow the process to run more smoothly. And, it’s a process often overlooked when discussing ‘what is an LLC operating agreement’.
Other provisions covers sections that may apply to some businesses but have not been addressed by any of the areas discussed above. Examples of other provisions include a liability statement, provision for the death of a member, member dispute, check-signing restrictions, and any other special agreements.
WHAT HAPPENS IF YOU DON’T HAVE AN OPERATING AGREEMENT?
All LLC companies should have an operating agreement. Although they are only legally required in six states it is highly recommended that you create an operating agreement from the outset when you form an LLC.
If you do not create one, your business will be run by the default LLC laws that govern your state. This means you will lose control over how you would like the business to be run. And, there are several other complications you may stumble into in the absence of an operating agreement, see below.
JEOPARDIZE YOUR LIMITED LIABILITY STATUS
Without an operating agreement in place, the limited liability status of the company can be challenged in court. It may be decided that the company is being run as a sole proprietorship. This means your personal assets could be on the line in the event of a legal claim.
LEAD TO OWNERSHIP CONFLICT
An operating agreement clearly defines ownership and how profits are to be split amongst company members. Without this level of clarity in writing, there may be conflict between members concerning the distribution of company profits.
NEGLECT OF ROLES & RESPONSIBILITIES
Without an operating agreement members and managers may neglect their roles and responsibilities. By codifying these in writing each member is clear of the role and responsibilities of all other members.
LOSE CONTROL TO STATE LAWS
The most immediate effect of not putting an operating agreement in place means your company will be run by the default LLC laws of your local state. In effect, this means you will have no say in how the business is managed and have missed an opportunity to put in place a management structure that works best for you and the other company members.
- WHAT IS AN LLC?
- HOW TO FORM AN LLC
- ADVANTAGES & DISADVANTAGES OF LLC
- USING AN LLC FORMATION SERVICE
- WHAT IS A REGISTERED AGENT FOR AN LLC?
- PROS & CONS OF LLC FILING COMPANIES
- PROS & CONS OF A REGISTERED AGENT SERVICE
OTHER COMPANY STRUCTURES
ABOUT THE AUTHOR
Erik is a 30-year industry veteran with a wealth of experience in cross-functional areas ranging from business consulting to business education. He has worked in the private sector where he has advised start-up enterprises on early formation, capital acquisition, and tax issues.
While he specializes in business formation he has also held roles in several academic institutions where he teaches organizational decision-making, business strategy, and operations management. Erik is a graduate of the McCombs School of Business at the University of Texas at Austin.