An operating agreement is an important document that is used by Limited Liability Companies (LLCs) to outline the business’s financial and functional decisions. The document is meant to govern the internal running of the business in accordance with the unique needs of the company’s owners.
According to the U.S. Small Business Administration (SBA), these are the reasons why it’s important to have an operating agreement:
- In order to safeguard the business’ limited liability status as operating agreements afford members protection from personal liability to the LLC. Without this particular formality, the LLC may be too closely resembled to a sole proprietorship or a partnership, which puts your personal liability in danger.
- In order to elucidate verbal agreements because even if members have orally come to some sort of agreement to specific terms, misunderstandings or miscommunication is still a distinct possibility. That’s why it’s always a good idea to have the operational conditions and other orders of business in writing. This way, they are always available for consultation should there be any misunderstandings or quarrels.
- In order to protect your agreement in the eyes of the state as state default rules will apply to LLCs which do not have an official operating agreement. These rules tend to be fairly general so it’s mostly not a good idea to have a governing body state take control of your agreement.
Contents
What does an LLC Operating Agreement Include?
Although the way operating agreements are set out may differ, and the content thereof may change, most contain the following six key sections: Organization, Management and Voting, Capital Contributions, Distributions, Membership Changes, and Dissolution.
Article I: Organization
This section deals with the formation of the business, and states when the business is formed, who the members are, and the structure of the ownership. Should there be more than one member, they might all have equal ownership or varying amounts of “units” of ownership.
Article II: Management and Voting
This section outlines the way in which the business is managed and the manner in which the members vote.
- The business may be managed by all of the members, only one of them, or by managers who are chosen and appointed by the members. The operating agreement outlines the power that the members or more have over business affairs.
- The business may decide to make decisions through a voting process, and votes may be assigned amongst the members in numerous ways. This includes one vote per member, or one vote per unit of ownership interest (should the business be set out in terms of units). The operating agreement thus establishes what amount of votes is necessary for a specific action to be taken by the business.
Article III: Capital Contributions
This section sets out which members have contributed financially to the formation of the LLC. It also considers how excess money will be raised by members. As an example, LLCs can decide to allocate ownership “units” in exchange for money.
Article IV: Distributions
This section outlines how the business’s profits and losses are divided amongst members including money, physical property, or any other company assets.
Article V: Membership Changes
This section highlights the process for the addition or removal of members. It also discloses if and when members are able to transfer their ownership of the business. As an example, this section outlines what occurs if a member dies, a member becomes bankrupt, or of two members divorce.
Article VI: Dissolution
This section of the operating agreement details the conditions in which the business may or may not be dissolved. This is occasionally referred to as “winding up” the affairs of the business.
Other topics often included:
Operating agreements may include numerous other topics and are dependent on the nature of the business. These could include preconditions for periodic meetings, limitations on check signing, or outlining the manner in which arguments within the business will be taken care of. It’s important to remember that the operating agreement can be amended throughout the process.
Does your state require an operating agreement for an LLC?
There are only six states where LLCs are legally obligated to have an operating agreement and they are California, DElaware, Maine, Missouri, Nebraska, and New York.
They are still recommended, however, especially if you have business partners (multi-member LLC) or if you are the sole owner of an LLC (single member LLC). If it’s a multi-member LLC then it helps prevent misunderstandings, and if it’s a single member then it helps to bring credibility to your business and makes sure that courts will uphold the limited liability status of your LLC.
You are able to download a free LLC operating agreement template from TRUiC to get an idea of what is needed, or you could also create a custom LLC operating agreement on the same site.
