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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 has multiple members, 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:
- Management and voting
- Capital contributions of members
- Membership changes
Why You Need an Operating Agreement
There are several reasons why you need an operating agreement, including:
- Clarifies verbal agreements: The 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.
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.
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 Formation, 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.
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 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.
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.
Basic Provisions in an Operating Agreement
Most operating agreements include the following basic provisions:
- 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 taxes, 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
There are some other types of provisions that companies commonly include in operating agreements, including:
- 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.
Meet some of our Operating Agreement Lawyers
I joined Enterprise Law Group, LLP as an Associate in March 2020. My practice has involved a wide range of legal matters from commercial real estate, finance and international business transactions to litigation matters including commercial disputes, personal injury and medical malpractice. Proficient in Spanish, I graduated from the University of Kentucky College of Law, the Patterson School of Diplomacy and International Commerce, and the University of Southern California. Prior to my legal career, I sought diverse professional experiences. After graduating from college, I orchestrated my own volunteering experience in southern Peru with a small non-profit organization. Later I gained valuable professional experience as part of a U.S. Senate campaign, and after that I joined the public policy team at Greater Louisville, Inc., Louisville's Chamber of Commerce affiliate. Prior to law school, I embarked on a month long excursion with the Northern Outdoor Leadership School in Alaska, which gave me a new found appreciation for sustainability.
Agnes Mombrun Geter is the Founder and Managing Attorney of Mombrun Law, PLLC. She is an experienced attorney and is a member of the Florida Bar, New Jersey Bar, and the Pennsylvania Bar. The firm's practice focuses on Estate Planning, Business Law, and Debt Settlement including IRS Debt Relief. The firm's goal is to simplify the law and provide clients with the confidence and information necessary to make their decisions. The firm also provides project-based legal services to other attorneys and law firms, along with assisting as personal counsel and local counsel on legal matters.
Have over 40+ years of corporate and commercial law experience.
I am a business attorney with years of experience advising individual entrepreneurs and small businesses on issues ranging from entity selection/formation to employment law compliance, to intellectual property protection and exploitation. I often act as General Counsel for my clients fulfilling the legal function as part of a team of managers. I look forward to learning more about your business and how I may be of assistance.
Corporate and transactional attorney in sixth year of practice. Focus areas include general corporate counsel, labor and employment law, business partnership matters, securities matters related to privately-held companies, and regulatory compliance in securities and finance matters.
Forest is a general practice lawyer. He provides legal advice regarding small business law, contracts, estates and trusts, administrative law, corporate governance and compliance. Forest practiced complex commercial litigation in Florida for eight years, representing clients such as Host Marriott, Kellogg School of Business, and Toyota. Since moving to Nashville in 2005, he has provided legal advice to clients forming new businesses, planning for the future, and seeking funding through the use of equity and/or debt in their businesses. This advice has included the selection of business type, assistance in drafting and editing their business plans and offering material, reviewing proposed term sheets, and conducting due diligence. Forest is a member of the Florida, Tennessee, and Texas Bars; in addition. Forest has held a Series 7, General Securities Representative Exam, Series 24, General Securities Principal, and Series 63, Uniform Securities Agent State Law.
CA, NY, and FL licensed attorney with nearly a decade of experience in intellectual property, data privacy, commercial contracts, and employment. I also have both the CIPP/US and CIPP/E privacy credentials. Basically, everything your business needs!