Operating Agreement: Definition, Terms, Considerations

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 between members.

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 and formalizes policies and procedures, 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.

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.

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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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