When starting a business, companies will draft charter documents to create the company. For a corporation, this will be Articles of Incorporation. For a limited liability company (LLC), it is Articles of Organization. Articles of Organizations are filed with the Secretary of State, of the state in which you choose to register your business in to legally form your business.
Either congruently, or once the Articles of Organization are filed and accepted by the state, companies should draft internal legal documents that explain the rules and regulations that will govern the business. For corporations, those are corporate bylaws. For an LLC, it is called an LLC operating agreement. These documents do not have to be filed with the state.
This article will explain why an LLC operating agreement is such an important document to create at the time of LLC formation. It will discuss the key elements that make up an operating agreement, and how to write an operating agreement for an LLC.
We make business formation EASY. Learn about our DIY business formation services here.
Why You Need an LLC Operating Agreement
While operating agreements aren't mandatory in all states, it's a good idea to have one prior to launching an LLC. It's not uncommon for friends and family members to go into business together based on a verbal understanding, especially if it's a small business. But it is best to take the time to prepare a written operating agreement right from the start. Having an operating agreement will provide many benefits, such as:
- Laying out how your LLC will operate: Taking the time to write an agreement ensures everyone is on the same page with how you will be operating your business.
- Breaking down how much each person will own and who will do what: If your LLC is multi-member, you will want to break down how much each member owns and/or contributes to the business. For example, if there are three members, each member may be an equal owner of 33.33% of the business. On the other hand, you may decide that one person owns 50% of the business and the other two members split the other half 25/25.
- Avoiding misunderstandings and potential legal action among owners: When everyone knows the rules, there is far less chance for misunderstandings that can detract from the smooth operation of the business.
- Protecting the assets of business owners from personal liability: Having a written operating agreement in place protects the limited liability status of the business owners should the courts look for assets to satisfy an obligation of the business. The owners' personal assets are protected.
- Avoiding state default rules: Many states have default rules that say that losses and profits should be divided equally among all the owners of the LLC, regardless of their respective ownership interests. Your LLC can avoid this default rule by agreeing that the share of losses and profits will be split according to the percentage ownership of each member.
- Opening a business bank account: Many banks will ask to see your operating agreement in order to open your business bank account. For some banks, this is a requirement. Your LLC should have its own bank account, separate from your personal bank account. As such, oftentimes banks will ask to see your operating agreement to assess such things as member ownership percentage.
- Laying out how the business will close (aka dissolve): In the event you and the members of the LLC decide to close the business, the operating agreement will provide a breakdown of how that is going to happen: i.e. how you will pay any debts owed and how you will split the remaining funds of the business.
What To Include in Your LLC Operating Agreement
LLC operating agreements tend to follow a template, although the details may vary. A majority of operating agreements include the following provisions and amendments:
- Name of the Business
- Statement of Intent: This is a legal document under the laws of your state and when the Articles of Organization are filed with the state, this agreement becomes legally binding and operational.
- Business Purpose: In this paragraph, you will explain the nature and purpose of your business. Be sure you allow some flexibility for your business to change and grow by including a phrase like "and for any other lawful business purpose."
- Terms: This sets a timeframe for the life of the business. Usually, the operating agreement says the business will continue “until terminated or dissolved according to state law."
- Business Structure: A business with a limited liability status can take two forms under the IRS code: multi-member LLC or single-member LLC (sole proprietorship).
- Members and Managers: This section lists the initial members of an LLC, along with their titles and addresses. It also lists managers, if there are any at the beginning stage of the business. The next few sections then relate to member rights and ownership.
- Member's Rights: Members have voting rights, as well as financial rights, and a right to information. Under state law, members can ask for information from the LLC if it relates to their business interests. This could be financial reports, membership lists, proof of contribution of funds by all members, and more. In general, there are two voting rights schemes that LLCs commonly use. In the first, each member votes their membership percentage. A person with a 40% ownership share has more voting power than a person with a 10% ownership share. The other voting scheme gives each member one vote, no matter the size of their ownership share.
- Member Capital Contributions: The operating agreement will include a breakdown of the ownership percentage. Most of the time, the ownership percentage is determined by the amount a member gave at the start of the business, compared to the total amount given by all members. You do not have to follow this ownership percentage scheme. You can allocate the ownership of the LLC any way you wish so long as you explain it in your operating agreement.
- Membership Changes: Your LLC's operating agreement should lay out the procedures for the transition of ownership. It should explain how new members join the business and how existing members can leave the business (sale, death, or disability). This section will include buy-sell rules. Most often, operating agreements include a simple buyout scheme that allows new members to buy out the ownership share of a member that is leaving the company.
- Management Plan: The operating agreement should also clearly define the management structures and procedures for business decision-making.
- Distribution of Profits and Losses: An allocation of a business's profits and losses is called a “distributive share." Under most LLC operating agreements, a member's distributive share is determined by their ownership percentage. For example, if Dave owns 25% of ABC LLC, and the operating agreement dictates that a member's distributive share is equal to his or her ownership share, Dave would take 25% of ABC LLC's profits (or losses). If ABC LLC made $100,000 in profits for the year, Dave would be entitled to $25,000. Your LLC operating agreement can include special arrangements. For example, a startup business may want to limit the share of profits that members can take in the early years to ensure enough operating capital for business growth. In the example above, Dave may only be allowed to take half of his distributive share, or $12,500, in the first year, leaving the remainder in the business.
- Rules for meetings: While your state's laws may not specify that LLCs must have owners' meetings and keep minutes, actually having such meetings can be helpful in proving that the business operates with the formalities of a legal business entity. Your LLC operating agreement should detail the frequency of corporate meetings.
- Dissolution of the Business: Your operating agreement should specify how your business will end. That could be triggered by the death of a member or by a vote of the members.
How to Write an Operating Agreement for Your LLC
You can work with a business attorney to draft an operating agreement to start an LLC, or you can look at LLC operating agreement templates online. See FindLaw's Business Formation section for legal forms and services.
Additional Resources on LLCs
Get Professional Legal Advice With Your LLC
When starting a new business, it's good to know that you have carefully followed the laws of your state. By working with a law firm that focuses on small businesses, you can have confidence that your business is off on the right foot. Consult an experienced, local small business attorney.