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An operating agreement is a legal document that outlines the operational procedures, internal structure, and ownership rights of a limited liability company (LLC). While many states do not mandate drafting an operating agreement, having one can be advantageous for an LLC to establish clear guidelines. In addition, operating agreements offer flexibility, safeguard member interests, and help prevent conflicts for better regulatory compliance.
What is an Operating Agreement?
An operating agreement is a legally binding document that limited liability companies (LLCs) use to outline how the company is managed, who has ownership, and how it is structured. If a company is a multi-member LLC, the operating agreement becomes a binding contract between the different members. In addition to clarifying ownership and structure, the operating agreement can also name the registered agent, give details like when meetings are held, select managers, and explain how the business can add or drop members. Simply put, the operating agreement outlines a business's functional and financial decisions. Once the members of the LLC sign it, they are officially bound to its terms.
Most operating agreements contain six key sections, including:
- Organization
- Management and voting
- Capital contributions of members
- Membership changes
- Distributions
- Dissolution
Why You Need an Operating Agreement
- Clarifies Verbal Agreements: The LLC operating agreement puts all agreements between the managing members in writing, so there are no misunderstandings. Members can then refer back to the operating agreement in the event of conflicts in the future.
- Protects Members from Personal Liability: The operating agreement is a formality that protects the managing members from being personally liable.
- Ensures You Aren't Subject to Default State Rules: When a business doesn't have an operating agreement in place, the default rules set by the state will apply. For example, states have default rules that require the company to divide profits and losses equally. To avoid having to rely on your state's basic operating rules, you should have an operating agreement in place.
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What to Include in Your Operating Agreement
There are a wide number of topics that you should address in your operating agreement. Some of these will depend on the needs of your business and your particular situation. However, most operating agreements should include:
- Members' Percentage of Ownership: The owners of a company usually make contributions of services, cash, or property to get a business up and running. Typically, they receive a percentage of ownership that's proportionate to the capital they contributed when starting the business. That said, members are welcome to divide ownership any way they like. However, ownership percentages should be clearly defined in the operating agreement.
- Distributive Shares: Distributive shares refer to the sharing of profits and losses. Oftentimes operating agreements will allocate distributive shares in the same way as the percentage of ownership. For example, if you own 25% of a business, you would then receive 25% of the profits and losses. However, you don't have to follow this rule. You could give an investor 25% ownership of a business but only assign them 10% distributive shares. That said, if you do choose to assign distributive shares that aren't in proportion to the ownership percentages, you will still have to follow the rules for special allocations.
- Allocation of Profits and Losses: Your operating agreement should also clearly define how much of the allocated profits should be distributed to members every year. It should also answer whether the members can expect the business to pay them enough to cover the cost of the income taxes they will owe on profits. In addition, it should articulate whether the owners are allowed to draw money from the business's profits at will or whether distributions will be made regularly.
- Voting Rights: The operating agreement should also explain how you will handle voting on major decisions. For example, will each member have one vote, or will each member have voting power that corresponds to their ownership percentage?
- Transitions in Ownership: It's important to have a plan in place that is clearly articulated in the operating agreement for how you will handle situations if one of the members decides to retire, passes away, or wants to sell their interest in the company. Your operating agreement should include rules for what will happen if a member decides to leave for any reason.
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How Operating Agreements Work
Because an operating agreement spells out an LLC's terms according to the members, it's a good idea to create one during the startup phase of your business, as it brings in clarity for future management and operations. While operating agreements aren't mandatory in all states, it's a good idea to have one, since it protects the company, prevents future misunderstandings between owners, and establishes rules for how you will run the business. Once the operating agreement is complete and signed by all members, it should be kept in a safe location to refer back to as necessary.
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Operating Agreement vs. Articles of Organization
Both of these are important documents when you're starting an LLC. However, the Articles of Organization, also referred to as the Certificates of Organization, are filed with the state to register it as a legal business entity. The operating agreement is an internal document. While it's legally binding in the same way that the articles of organization are, it doesn't need to be filed with the state.
Types of Operating Agreements
While not always mandated by law, having a well-prepared operating agreement is highly advised for any limited liability company to prevent conflicts and ensure seamless operations. Below are the common types of operating agreements and their important characteristics:
- Standard Operating Agreement: The standard operating agreement is the most common type and is a baseline template for many LLCs. It outlines essential provisions, such as the LLC's purpose, members' roles and responsibilities, capital contributions, profit and loss allocation, management structure, and decision-making processes. This type of agreement is relatively straightforward and works well for smaller LLCs with a simple ownership structure and uncomplicated internal operations.
- Member-Managed Operating Agreement: In a member-managed operating agreement, all associates of the limited liability company have an active part in the organization's administration and decision-making functions. This operating agreement is appropriate for smaller limited liability companies where all members actively participate in the organization's day-to-day affairs.
- Silent Member Operating Agreement: A silent member operating agreement is designed for individuals who want to be passive investors in the LLC. Silent members provide funds to the organization but have little or no involvement in the business's administration or decision-making procedures. This type of agreement is used in real estate undertakings or other investment-focused LLCs, where certain members prefer to invest funds without engaging in the business's daily functions.
- Vesting Operating Agreement: A vesting operating agreement incentivizes key members or employees to remain with the company for a specified period. The agreement outlines a vesting schedule, where ownership or profit-sharing rights are gradually earned. This arrangement helps promote loyalty and commitment among key individuals and discourages them from leaving the company prematurely, as they would forfeit some of their vested rights.
- Buy-Sell Operating Agreement: A buy-sell operating agreement addresses how ownership interests are transferred or sold if a member leaves the LLC voluntarily or involuntarily due to death or disability. It specifies a framework for valuing the organization, the terms of the buyout, and the rights and limitations on ownership interest transfer. This type of agreement is essential for long-term business continuity and prevents conflicts over ownership transitions.
Primary Objectives of an Operating Agreement
Although not obligatory in numerous jurisdictions, an operating agreement is a useful tool for ensuring seamless procedures, clarifying roles and obligations, and safeguarding the claims of all members or owners. Below are the primary objectives of an operating agreement:
- Defining Functions and Responsibilities: One of the primary roles of an operating agreement is to determine the functions and obligations of the LLC's members and administrators. In addition, it defines who has decision-making power, each member's contribution, and how earnings and losses will be allocated.
- Ensuring Conflict Resolution: In disagreements or disputes among members, the operating agreement offers a framework for settling these issues. It can help prevent expensive legal actions and maintain the stability of the limited liability company.
- Offering Asset Protection: The operating agreement can include provisions that protect the members' personal assets from the business's liabilities. It is a fundamental aspect of the limited liability protection that LLCs offer.
- Establishing Tax Structure: The operating agreement can help determine the LLC's tax structure by specifying how profits and losses are distributed among members. It provides flexibility in choosing between pass-through taxation or electing corporate taxation.
- Planning Exit Strategies: An operating agreement can outline the procedures for selling or transferring membership interests and the terms and conditions for the withdrawal or dissolution of the LLC. It ensures a clear roadmap if a member decides to leave or the business needs to be wound down.
Basic Provisions in an Operating Agreement
- Name of the LLC: The operating agreement should always include the name and address of the registered office and business office.
- Statement of Intent: This states that the agreement is in accordance with state laws and comes into existence when the official documents are filed.
- Business Purpose: This statement defines the business's purpose, including the nature of the business, and often includes a statement like "and for any other lawful business purpose" to cover the business in the event of future changes.
- Term: This states that the business will continue until terminated or dissolved according to state law.
- Tax Treatment: This articulates how the business will be taxed, whether by a partnership, sole proprietorship, or corporation.
- New Members: This outlines how a potential new member could acquire an interest in the business.
Other Types of Provisions in an Operating Agreement
- Identification of Managers and Members: This lists the names, titles, and addresses of the initial members and any managers if there are any.
- Capital Contributions: This lists the initial capital that each member contributes and what the value is.
- Additional Capital Contributions: This states whether members are allowed to make additional contributions and whether it's required.
- Member Meetings: This outlines when meetings will be held and any rules that apply in meetings.
- Dissolution: This provides procedures and conditions for dissolving the business.
While the provisions and topics presented above are the major provisions that companies tend to include in their operating agreements, the list is by no means exhaustive. Because it's a document made specifically for your company to address circumstances you anticipate encountering, you can essentially include anything you want. For example, you could include restrictions on who is allowed to sign a check or how disputes will be resolved.
It's also important to keep in mind that the operating agreement, while legally binding, can be changed at any time through the process of your choosing. That means that as the company grows and changes, you can make changes as necessary to meet the needs of the business and its members.
There are a lot of practical, legal, and even tax considerations that you may want to consider as you're tailoring your operating agreement for your business's needs.
Final Thoughts on Operating Agreements
An Operating agreement is an important document for every limited liability company, as it specifies the regulations, rights, and obligations governing the organization's internal affairs. Therefore, by setting a transparent structure for profit allocation, decision-making, and conflict resolution, the Operating Agreement plays a vital part in an organization's long-term success and sustainability.
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Meet some of our Operating Agreement Lawyers
Morgan S.
Corporate Attorney that represents startups, businesses, investors, VC/PE doing business throughout the country. Representing in a range of matters from formation to regulatory compliance to financings to exit. Have a practice that represents both domestic and foreign startups, businesses, and entrepreneurs. Along with VC, Private Equity, and investors.
Karl D. S.
Karl D. Shehu, has a multidisciplinary practice encompassing small business law, estate and legacy planning, real estate law, and litigation. Attorney Shehu has assisted families, physicians, professionals, and people of faith provide for their loved ones by crafting individualized estate and legacy plans. Protecting families and safeguarding families is his passion. Attorney Shehu routinely represents lenders, buyers, sellers, and businesses in real estate transactions, researching and resolving title defects, escrowing funds, and drafting lending documents. To date, Attorney Shehu has closed a real estate deal in every town in Connecticut. As a litigator, Attorney Shehu has proven willing to engage in contentious court battles to obtain results for his clients. While practicing at DLA Piper, LLP, in Boston, Attorney Shehu represented the world’s largest pharmaceutical companies in multidistrict litigations filed throughout the United States. He has been a passionate advocate for immigrants and the seriously injured, frequently advising against lowball settlement offers. He is willing to try every case to verdict, and he meticulously prepares every case for trial. Attorney Shehu began his legal career as a consumer lawyer, utilizing fee-shifting statutes to force unscrupulous businesses to pay the legal fees of aggrieved consumers. For example, in Access Therapies v. Mendoza, 1:13-cv-01317 (S.D. Ind. 2014), Attorney Shehu utilized unique interpretations of the Trafficking Victims Protection Act, Truth-in-Lending Act, and Racketeer Influenced and Corrupt Organizations Act (RICO) to obtain a favorable result for his immigrant client. Attorney Shehu is a Waterbury, Connecticut native. He attended Our Lady of Mount Carmel grammar school, The Loomis Chaffee School, and Chase Collegiate School before earning degrees from Boston College, the University of Oxford’s Said Business School in England, and Pepperdine University School of Law. At Oxford, Karl was voted president of his class. Outside of his law practice, Attorney Shehu has worked to improve the world around him by participating in numerous charitable endeavors. He is a former candidate for the Connecticut Senate and a parishioner of St. Patrick Parish and Oratory in Waterbury. In addition, Attorney Shehu has written extensively on the Twenty-fifth Amendment and law firm retention by multinational firms.
Rene H.
I am an attorney licensed in both California and Mexico. I offer a unique blend of 14 years of legal expertise that bridges the gap between diverse legal landscapes. My background is enriched by significant roles as in-house counsel for global powerhouses such as Anheuser-Busch, Campari Group, and Grupo Lala, alongside contributions to Tier 1 law firms. I specialize in navigating the complexities of two pivotal areas: AI/Tech Innovation: With a profound grasp of both cutting-edge transformer models and foundational machine learning technologies, I am your go-to advisor for integrating these advancements into your business. Whether it's B2B or B2C applications, I ensure that your company harnesses the power of AI in a manner that's not only enterprise-friendly but also fully compliant with regulatory standards. Cross-Border Excellence: My expertise extends beyond borders, with over a decade of experience facilitating cross-border operations for companies in more than 20 countries. I am particularly adept at enhancing US-Mexico operations, ensuring seamless and efficient business transactions across these territories.
Octavia P.
I am a business law attorney with over 10 years’ experience and a strong background in information technology. I am a graduate of the University of California Berkeley, a member of the Illinois bar and a licensed lawyer (Solicitor) of England and Wales. I actively partner directly with my clients or indirectly, as Of Counsel, to boutique law firms to streamline business practices and manage legal risks by focusing on essentials such as - business contracts, corporate structure, employment/independent contractor agreements, website terms and policies, IP, technology, and commercial related agreements as well as business risk and compliance guidance.
January 20, 2021
Elizabeth R.
Elizabeth is an experienced attorney with a demonstrated history of handling transactional legal matters for a wide range of small businesses and entrepreneurs, with a distinct understanding of dental and medical practices. Elizabeth also earned a BBA in Accounting, giving her unique perspective about the financial considerations her clients encounter regularly while navigating the legal and business environments. Elizabeth is highly responsive, personable and has great attention to detail. She is also fluent in Spanish.
December 8, 2020
Abby V.
Abby is an attorney and public policy specialist who has fused together her experience as an advocate, education in economics and public health, and passion for working with animals to create healthier communities for people and animals alike. At Opening Doors PLLC, she helps housing providers ensure the integrity of animal accommodation requests, comply with fair housing requirements, and implement safer pet policies. Abby also assists residents with their pet-related housing problems and works with community stakeholders to increase housing stability in underserved communities. She is a nationally-recognized expert in animal accommodation laws and her work has been featured in The Washington Post, USA Today, Bloomberg, and Cosmopolitan magazine.
January 4, 2021
Matan S.
Matan is an experienced M&A, corporate, tax and real estate attorney advising closely held businesses, technology start ups, service businesses, and manufacturers in purchases, sales, and other exit strategies. Matan works with founders and first-and-second generation owners to strategically transition businesses.
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Browse Lawyers NowLimited Liability Company
Operating Agreement
California
Draft an operating agreement in multi member LLC
Hi, a friend and I plan to register an LLC together. We would like to purchase rental units which would be owned by this LLC, and would like to have an operating agreement between us under this LLC. What do we need to know, and who should we talk to?
Paul S.
You will need to know what the equity split will be, and if it is 50/50, how will you manage tie votes. How will profits and losses be allocated? How will the LLC be managed? What happens if one of you wants to sell to a third party or leave the LLC?
Business Contracts
Operating Agreement
Texas
Do I need to file my Operating Agreement in Texas?
I know I need one but does it go with State filing?
George O.
No, but you definitely need to have one, preferably reviewed and prepared by a lawyer; there are a lot of businesses that will give you templates, etc., but do not have the experience and knowledge that a lawyer brings to the table.
Business Contracts
Operating Agreement
Connecticut
What is the risk in using a free template I found online for an operating agreement?
I found an operating agreement on a website. I need one and want to know if it is OK to use. I am starting an e-commerce company with my family member.
Jane C.
Many templates can be a great starting point, however; they may contain clauses that do not relate to your business that create unintended consequences. Disclaimer - This information is provided for general informational purposes only. No information contained in this post should be construed as legal advice and does not establish an attorney-client relationship.
Limited Liability Company
Operating Agreement
Florida
Forming LLC with multiple members
Hello, Looking to form LLC with 3 other individuals. What would be the best route to go?
Bruce B.
In florida you would want to have an operating agreement to specify the relationship between the members.
Real Estate
Operating Agreement
District of Columbia
Review Operating Agreement for Real Estate Investment
I am planning to invest in LLC who is developing a project as class b share holders with fixed return Wanted to get advise on security of the investment
Jane C.
There are many attorneys on Contracts Counsel that can assist you with this matter.
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