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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
Jennifer is an experienced business law attorney who has worked with many startups as well as established corporations. With a strong background in contract creation and review, she will be able to ensure you and your business interests are always protected.
I am a corporate lawyer with expertise working with small businesses, venture capital and healthcare. Previously, I worked at large law firms, as well as head attorney for companies. I graduated from Harvard College and University of Pennsylvania Law School. I speak 5 languages (Spanish, French, Italian and Russian, plus English), visited over 60 countries, and used to compete in salsa dancing!
I am a licensed attorney and a member of the California Bar. I graduated from the University of Dayton School of Law's Program in Law and Technology. I love IP, tech transfers, licensing, and how the internet and developing technology is changing the legal landscape. I've interned at both corporations and boutique firms, and I've taken extensive specialized classes in intellectual property and technology law.
Jo Ann J.
Jo Ann has been practicing for over 20 years, working primarily with high growth companies from inception through exit and all points in between. She is skilled in Mergers & Acquisitions, Contractual Agreements (including founders agreements, voting agreements, licensing agreements, terms of service, privacy policies, stockholder agreements, operating agreements, equity incentive plans, employment agreements, vendor agreements and other commercial agreements), Corporate Governance and Due Diligence.
I am an unabashed contract law geek with a passion for delivering contracts that protect your business within your risk tolerance. Contracts should be clear, concise, and able to be understood by the end user. I promote Plain English contract drafting. I also pay close attention to the boilerplate traps that trip up many agreements. Some of my most frequent drafting projects are entity operating and shareholder agreements, bylaws, asset purchase agreements, commercial leases, EULA, Terms of Service, Privacy Policies, Confidentiality agreements, employment agreements, and more.
I hold a B.S. in Accounting and a B.A. in Philosophy from Virginia Tech (2009). I received my J.D. from the University of Virginia School of Law in 2012. I am an associate member of the Virginia Bar and an active member of the DC bar. Currently, I am working as a self-employed legal consultant and attorney. Primarily my clients are start-up companies for which I perform various types of legal work, including negotiating and drafting settlement, preparing operating agreements and partnership agreements, assisting in moving companies to incorporate in new states and setting up companies to become registered in a state, assisting with employment matters, drafting non-disclosure agreements, assisting with private placement offerings, and researching issues on intellectual property, local regulations, privacy laws, corporate governance, and many other facets of the law, as the need arises. I have previously practiced as an attorney at a small DC securities law firm and worked at Deloitte Financial Advisory Services LLC. My work experience is dynamic and includes many short-term and long term experience that span across areas such as maintaining my own blog, freelance writing, and dog walking. My diverse background has provided me with a stong skill set that can be easily adapted for new areas of work and indicates my ability to quickly learn for a wide array of clients.
Texas licensed attorney specializing for 20 years in Business Law, Contract Drafting, and Risk Analysis. My services include: Corporate Risk Consulting; Contract Review and Drafting; Legal Research and Writing; Business Formation; Article or Instructive Writing; and more. For more insight into my skills and experience, please feel free to visit my LinkedIn profile or contact me with any questions.