How to draft an LLC operating agreement

 

An operating agreement is a core founding document of a limited liability company (LLC). And while most states don't require a limited liability company to have one, entrepreneurs should think twice before deciding to function without an operating agreement.

If you ask three different business owners how to draft an operating agreement for a limited liability company, you'll get three different answers. That's because what you include in this legal document will depend on your business' goals and needs. 

"There's no right or wrong. It's how your team wants to do it for themselves and what makes sense in their situation," says Hal Shelton, a business executive and author of "The Secrets to Writing a Successful Business Plan." "The operating agreement sets the guidelines of how you're going to operate on key factors, (so) that when issues arise, they can be solved more easily."

Such issues may include a manager's duties, expectations for a member's contributions, the company's profits, how to handle company assets, new members, internal operations, business plan, and other company affairs.

No two LLC operating agreements are exactly alike, although they all have the same purpose, which is to detail exactly how a business is to be run.

In this guide, we'll explain what an LLC operating agreement does, how to make one, and why it's a valuable consideration for the LLC's members.

What is a limited liability company?

A limited liability company is a flexible business structure that offers its owners, who are called members, limited personal liability protection that separates their personal assets from the company's debts and legal liabilities. This option provides members a sense of security and the ability to manage risk. Each state has its own rules for how LLCs must be created and governed, but it is generally a straightforward business formation that is easy to set up. You can have a single-member or multi-member LLC.

Many entrepreneurs choose the LLC structure because of its flexibility in terms of management and taxation. Members can opt to manage the limited liability company by themselves or appoint managers. And they can choose from various approaches to taxation. While a limited liability company is considered a pass-through entity by default, members can instead elect for the LLC to be taxed as a corporation if that would be more favorable financially. This versatility makes the LLC structure the go-to choice for small and medium-sized businesses.

What is an LLC operating agreement?

An LLC operating agreement establishes guidelines for a limited liability company in the same way that bylaws govern the operation of a corporation. The operating agreement is separate from the LLC's articles of association, which establish the company and lay out very general rules for operation.

"By opening an LLC or a similar entity, you're going to be bound by rules," says Robin Gerofsky Kaptzan, a partner and the Asia-Pacific chair at Zahn Law Group LLP. "The operating agreement is important because it gives you rules and regulations for the company to follow. By having those rules and following them, LLCs operate more efficiently."

Common provisions in an LLC agreement include a statement of intent, a business purpose, the time period during which it will operate, how it will be taxed, new LLC member admissions, and member capital contributions.

If there are multiple members in the LLC, this LLC agreement becomes a binding contract among all the members. A single-member LLC can (and may be required to) create an operating agreement as well, but the provisions will only apply to one member of the sole proprietorship.

Do I need an operating agreement for my LLC?

An LLC operating agreement is only a requirement in three states, but it is almost always a good idea to create this LLC operating agreement llc beforehand, even if your company only has one member. There are risks to doing business without an operating agreement. Even if an LLC operating agreement is not required by law, an operating agreement serves three important purposes:

1. An operating agreement allows you to decide how your business will work instead of those details being dictated by state tax laws and other regulations.

In the absence of an agreement, state rules govern numerous aspects of a limited liability company. In essence, state laws provide a standard operating agreement if you don't create your own. For example, some state default rules provide that members share equally in the profits, regardless of each member's contribution of capital or each member's interest in the company. With an operating agreement, you can define your own rules on that question and many others.

2. An operating agreement minimizes misunderstandings and disputes by making the details of your business arrangement clear to all members.

While it's helpful for a single-member LLC to have an operating agreement, the document really becomes invaluable in businesses with multiple members. An operating agreement ensures that each LLC member has the same understanding of their rights and responsibilities and agrees to how decisions and disputes should be handled within the business entity. Many issues may come up in multimember LLCs that are going forward without an operating agreement.

"If there's a lack of clarity, that can lead to problems between partners," says Joseph Piatchek, the managing attorney at the Piatchek Law Firm in Springfield, Missouri. "Even if an agreement isn't required, my sense is that it is a good idea."

3. An operating agreement ensures that you have protection from personal liability for any business-related legal challenges.

Setting up your LLC properly—including by having an operating agreement in place—helps you maintain an official separation between your personal and business affairs, which can make a huge difference if your business is sued. It's best to create a business structure with a separation between your company's business and personal property and assets. This can include your company's property and funds.

"If you're traveling on business, and you hit someone with a car, they might sue you," says Shelton. "They'll sue you or sue the company. If your company doesn't have lots of assets, they might try to sue you personally. So you need to build this wall between your personal life and your business life."

This "wall" is otherwise known as the corporate veil, and it can be easily "pierced"—that is, expose you to personal liability—if you are doing business without an operating agreement.

"The concept of the corporate veil is that it protects the individual or collective owners of a business from the potential risk of liability in the event of a dispute," says Kaptzan.

Is an LLC operating agreement legally required for my business?

Whether your LLC is required by law to have an operating agreement in place varies by state, but having an LLC operating agreement is almost never a requirement. The statutes in most states define what an operating agreement is for and what provisions one should have but don't typically require its creation.

Is an LLC operating agreement required for an LLC in Pennsylvania, Maryland, North Carolina, or Washington state? The answer is no. LLC operating agreements are only required by statute in Missouri, New York, and Maine. And even in these states, there are no requirements to file the agreement with the secretary of state; the LLC agreement is considered to be an internal document. In some states, LLCs can have verbal or even "implied" operating agreements, though that is not necessarily best practice.

Many LLC owners in all states aren't aware of the benefits of an operating agreement. And even in the states that require one, many LLC owners don't realize they must have one and end up unknowingly breaking the law.

"There are so many people who form the LLC themselves by filling out a few lines on a form and don't know that Missouri law requires an operating agreement," Piatchek says.

"They might not have any idea what an operating agreement is. In my experience, they usually figure it out after one month to five years, when something presents a problem for them."

Do I need an LLC operating agreement if I'm a single-member business?

A single-member LLC is considered the same as a multiple-member LLC from a legal perspective, so both types of LLCs must have an operating agreement in the states where it is required by statute. In all other states, sole proprietorships and LLCs with two or more members are not required to have an operating agreement.

However, creating one can still be a good idea even if you have no other members or aren't planning to take on new members.

The main reason a sole proprietorship might want an operating agreement is to establish that the company is being run properly, which reduces the chance of someone successfully suing the owner personally for a business mishap.

"Piercing the corporate veil would be the biggie that I would be worried about if I were a single-member," Piatchek says.

Such a company may want to have an operating agreement in place to lay out how to deal with outside contractors like accountants or freelancers or to lay the groundwork for adding additional members in the future.

"Drafting an operating agreement for a single-member LLC is easy," says Kaptzan. "However, some single-member owners take the approach of preparing it early with strong rules to put the business in a better negotiating position when bringing in another owner."

Bringing in somebody else is where things get complicated, after all.

"The main reason you would want an operating agreement is to cement what the agreements are between multiple members," Piatchek says.

"As soon as you add that second person, it can get a little bit more complex. You have to talk about voting rights and what happens when someone leaves."

Can I create my own operating agreement for my LLC?

Many LLC owners ask, "How do I make a simple LLC operating agreement?" It's a legal document, but you don't necessarily need a lawyer to help you, although legal expertise is a good idea.

Shelton advises startups to put in a lot of legwork to create the basics of the agreement, and then to use legal help to help finalize the document once the pieces are in place.

Hammering out the agreement can be a surprisingly emotional and fraught process, however, especially if you're partnering with loved ones, so it's a good idea to be open and take it slow.

"Sometimes, when you're working with family members or friends who have known each other forever, these conversations can be really hard," Shelton says.

"You have to have really up-front discussions. You have to put your feelings on the table. I would assume you probably cannot discuss and solve these in one sitting."

After you've memorialized the agreements you've made, "then I would turn to a lawyer," he continues. "You need to work out what's best for you and get a lawyer who's done these things to give advice and point out things you've missed."

Lawyers are also valuable in that they have the expertise to help business owners sift through what provisions are necessary and which will actually be enforceable.

"I don't recommend businesspeople who are non-lawyers practicing law by drafting their own corporate documents," says Kaptzan. "For one reason, they don't understand the ramifications of certain terms. Certain terms may be influenced by laws or regulations that render them unenforceable or simply trigger unknown obligations. When you hire a lawyer, terms should be tailored to whatever your needs and goals may be and help you plan for the growth of your business."

Basic info on an operating agreement for LLC owners

Any operating agreement for LLC businesses—including a single-member LLC operating agreement—typically includes the following basic types of provisions.

Identifying information

The name of the LLC; the addresses of the initial registered office and principal business office; and the names, addresses, and titles of the initial members (and managers, if any).

Statement of intent

A statement that the agreement is in accordance with the LLC laws of your state and that the business will come into existence once the official LLC documents have been filed with the state.

Business purpose

A statement of the purpose of the LLC, which should include the nature of the business. It often includes an additional statement, such as "and for any other lawful business purpose," in order to cover any changes you may wish to make later.

Term

For most LLCs, the operating agreement will state that the LLC will continue until it is terminated as provided in the agreement or until dissolved according to state law. An LLC formed for a specific purpose, such as constructing and selling a commercial building, may exist for a set period of time or until a certain event occurs.

Tax treatment

The statement should specify whether the LLC elects to be taxed as a sole proprietorship, partnership, or corporation.

"An LLC can be taxed as an S corp, C corp, partnership, proprietorship—there are so many ways it can be done," says Piatchek. "That's what makes the LLC so flexible."

Admission of new members

This provision outlines the manner in which someone may acquire an ownership interest in the LLC. If there is an entire agreement with no such provision and you later wish to add a partner, you can prepare a new operating agreement to define all the details all members must agree on.

Other common provisions in LLC operating agreements

You may also find it useful to include the following provisions in your operating agreement.

Initial capital contributions

Each partner may have contributed a certain amount of capital when they started the business, and it's a good idea to record these amounts, as they may influence other factors of the agreement. List the initial capital contributions of each member, which can be in the form of cash, property, or services.

"It's good to memorialize [in an LLC operating agreement] that Member A put in $10,000, Member B put in $7,000, and Member C put in $15,000," Shelton says. "This will be the first edition of the company's cap table."

Additional capital contributions

Sometimes a business must raise additional capital. Some LLC operating agreements say that no member can be required to make additional capital contributions themselves, whereas other operating agreements require it. If members make additional contributions, they can adjust each member's percentage of interest in the business.

Distribution of profits and losses

Typically, each member shares in the profits or losses according to his or her percentage of interest in the business. This section of an LLC operating agreement can also state how often profits will be distributed. Since an LLC's profits are passed on to and taxed on the members' personal tax returns, distributions must be sufficient to at least pay the taxes that each member owes.

"What are the rules to divide the profits and losses?" Shelton asks. "If you don't have this, it goes back to the default."

In most states, the default is to divide profits and losses to match each member's portion of ownership. If levels of ownership aren't defined in the agreement, the default may be to divide things equally, such that each member of a three-member LLC gets one-third of profits and losses.

However, some companies may want a different arrangement, such as a 60/20/20 split, and this must be laid out in the operating agreement.

Member meetings and voting

The LLC operating agreement should state if and when member meetings will be held and include any rules regarding how, when, and where votes will be taken; who has voting rights; how many voting members must be present for a quorum; how many votes are required to approve an action; and whether members can vote by proxy.

"People form LLCs because they get all the legal protection of a C corp, but they don't have to jump through all the hoops," Shelton says.

"They're not required to have board meetings and are not required to have a board. The question will be, 'Should we impose on ourselves that we will have an annual meeting and an annual budget and things of that nature?'"

The operating agreement can lay out specific details about meetings and voting, such as whether each member will get one vote or be allocated a number of votes equal to his or her percentage of interest in the LLC. The operating agreement can also state whether a majority or a unanimous vote is required to make a decision. It can define the appropriate size for a quorum based on the size of the business.

The LLC operating agreement can lay out what should happen in the event of a deadlock, which happens when a decision is impossible under the rules of the agreement. For example, a vote may be impossible if unanimity is required and one member disagrees. If the decision is important, such as whether to agree to a buyout offer, it's essential that there's some way to break the deadlock.

"If you end up with a deadlock, you should have a protocol that says how to make decisions," Kaptzan says.

"The protocol could be to hire an independent third party, a mediator, or an arbitrator to assist with decision-making. One other option for deadlock is splitting up or closing the business, which is extreme, but some companies want this drastic result."

Management

The LLC operating agreement can state whether the LLC will be member-managed or manager-managed. Details of member management can also be included in the operating agreement, such as what services members are expected to perform in operating the business and what salaries they will be paid. You can also lay out how managers will be elected, how long they will serve, and any limitations on their authority.

"Who has the authority to make what decisions?" Shelton asks. "When you're starting out, you might make decisions together. But that doesn't last very long, especially if the company is growing."

The operating agreement can lay out guidelines about what kinds of decisions each person gets to make and in what circumstances. An example is a stipulation that members can make independent decisions up to a certain dollar amount but must get unanimous approval for decisions that involve more money.

Admission and withdrawal of members

An operating agreement should include provisions for how new members may be admitted, what happens if a member wishes to withdraw, actions that will justify the expulsion of a member and the procedures for expulsion.

"Say that three friends graduate from college together and form a company," Shelton says. "One is the CEO, one's marketing, one's IT. Now it's time to bring in someone in engineering. How does that happen? What's the vote? Does it have to be unanimous? Does it just have to be a majority?"

Each member's buy-in matters here. If each member contributed sweat equity or $10,000, and a new member is set to join a year later, it's good to define what, if anything, that new member must contribute or how many options they get upon joining.

The same goes in the opposite direction for a withdrawing member or expulsion of a member.

"How is it that you expel someone from the island?" asks Shelton. "Is it a unanimous vote? Is it a majority vote? You need to document that procedure."

Restrictions on members

Members in the LLC may face a variety of restrictions that dictate how they can behave when doing business. Examples are noncompete, nonsolicitation, and noncircumvent agreements. The operating agreement should lay out whether these can or should be in place. In some cases, members may want to avoid these stipulations, such as if a member already owns a competing business. In such a case, the operating agreement could stipulate a more limited restricted clause.

"A business should create noncompete restrictions broad enough to protect the business so that the co-owners do not compete using knowledge acquired from the business," says Kaptzan. "However, sometimes a new co-owner won't accept grand restrictions, and a limited noncompete may be the best a co-owner can carve out."

Intellectual property

The operating agreement may want to define the ownership and other details of the company's intellectual property. For example, who owns the logo and the name? Who has the rights to any processes the company develops? Who has the right to the trade dress of the business?

Transfer of interest

An operating agreement should define how a member's LLC interest may be transferred, which is typically a "right of first refusal." That means that if a member wishes to sell, the other members have the right to buy out the departing member on the same terms offered by a potential third-party purchaser.

"If co-owners want to end the relationship, it is important to ensure their investment is protected," Kaptzan says. "It is important to determine the mechanism to value the shares."

The operating agreement could list various ways to do that valuation, including designating a person to assist in evaluation or using a formula to predetermine how you're going to calculate the fair market value.

Alternatively, the operating agreement could say that you will use a mediator, an arbitrator, or some other third-party valuation company.

The LLC operating agreement should include protocols to follow when someone sells their shares. That could include the right of first refusal and the type of notice the seller must give for that offer, as well as any other provisions that define how the situation should play out.

Death of a member

The LLC operating agreement can define what happens to a member's interest upon death. Common provisions include the remaining members purchasing the interest, allowing certain people (a spouse or child) to acquire the interest, or giving remaining members the right of first refusal before transfer to an heir.

"Sometimes you may need to restrict an heir's ability to step into the operations role of the deceased because the deceased person's role in the company was very significant," says Kaptzan. "The operating agreement should address if the new owner is capable of working for the company."

In such a case, a provision can be made that allows transfer but only gives the transferee the right to profits but not to participate in business decisions.

Dissolution

An operating agreement should set out conditions and procedures for dissolving the LLC. It's important to assess the types of situations that could trigger the company's closing. Such situations include the death of a member, members breaching the rules, and a deadlock that triggers a dissolution provision.

The operating agreement should also lay out the procedures for closing the business once a situation or decision has been put in motion.

“You always want to include in a termination clause with grounds that trigger the company's closure and also a protocol about how to handle the dissolution of the business," Kaptzan says.

“I prefer protocols that create very tight boundaries about how long it will take to perform a certain task so both parties are clear of what is expected of them and how long it will take for each phase of the process."

For example, if a valuation of the assets is required, the agreement can lay out the number of days allotted for that and require all members to agree on which company will do the valuation. The operating agreement can stipulate that all members need to approve the buyer of the assets, or it can say that one member will be responsible for handling the sale at a “reasonable price."

Detailing all these procedures and guidelines can make the difference between a streamlined dissolution and a messy one.

“Dissolution is like a divorce; it can go smoothly, or it could be a nightmare," Kaptzan says. “Having these kinds of rules in an operating agreement when you have more than one owner helps to minimize or eliminate stress and conflict."

Amending the agreement

Your operating agreement is not a static document that can never be changed. In fact, it's a good idea to amend your agreement as your company grows and evolves.

“No matter how hard you work, the operating agreement will reflect your knowledge, your feelings, and what's going on at the current time," Shelton says. “As you grow, as the company pivots, as the members change in and out, you will need to update the operating agreement."

For this reason, the LLC operating agreement should contain information about what kind of vote is required to amend it.

What are some potential pitfalls of not having an LLC operating agreement?

The list below provides only a few of the potential problems LLCs can run into if they lack an operating agreement. However, even this abbreviated listing will make it quite clear that having an LLC operating agreement for your business is a good idea.

Lack of control over your business

You may feel like you control your own business even if you don't have an operating agreement in place. But as soon as something goes wrong or changes in a way you don't know how to handle, it will become clear that your control only extends so far. That is because a state's default rules are in place in situations where you haven't defined your own way of doing things. Creating an operating agreement with your own rules and approaches laid out clearly is the best way to maintain as much control as possible and prevent any liability from arising.

Confusion over ownership

If your LLC lacks an operating agreement, there is likely to be confusion about what should happen when something changes in terms of ownership, such as when one member dies. If that member was married, the spouse may believe they are the new owner of the deceased's shares. Or perhaps a legal skirmish causes the remaining members to prove their joint ownership of the business, but there is no paperwork that lays this out clearly, leaving them vulnerable to unintended consequences.

Questions about what to do when someone leaves

If the names of the owners and the amounts of their ownership shares are not enshrined in an operating agreement, there can easily be disagreement about membership interest and initial contributions when one of them decides to depart. The withdrawing member may claim initial contributions that can't be backed up by financial records.

“You know how people rewrite history sometimes?" Piatchek says. “What if one of the owners says, 'I initially invested $5,000, and you just brought clients," then the other person says, 'Oh, no, no, no'?"

This is the reason that an operating agreement should memorialize the contribution that each partner made.

No guidance about how to resolve disputes

It's likely that every multi-member business will eventually face a dispute among its partners. When that happens, everyone will be relieved to have procedures for resolution spelled out in an operating agreement.

“If you and I are in business together and we have a dispute, certainly at some point that operating agreement is going to be the star of the show," says Piatchek, who includes a provision for alternative dispute resolution in many of the operating agreements he creates.

“It will say, 'If the members have a dispute, the first thing they'll do before suing each other is agree to go to a third-party mediator, and if that doesn't work, they may engage in arbitration before going to court,'" he says.

The idea is to head off ugly legal battles before they begin. Without an operating agreement, such issues may occur.

Vulnerability to piercing the corporate veil

Considering that one of the main reasons entrepreneurs set up LLCs is to secure some liability protection, it's in their best interest to ensure that protection is as robust as possible. Lack of an operating agreement, especially in states that require it, puts LLCs at risk. Someone pursuing the business in court could make a plausible argument that the business is improperly run and that the business owner should be personally liable. It's important to have an LLC operating agreement in place for personal protection.

“If I didn't have an operating agreement, piercing the corporate veil would be one thing I would be worried about," Piatchek says.

Follow your own rules

While this article covers major provisions of LLC operating agreements, this is not an exhaustive list of elements that may be included in an agreement. Many practical, legal, and tax considerations come into play in tailoring an LLC operating agreement to your specific needs.

Creating an effective operating agreement is about finding “what works for you," Shelton says. And in each case, there's precedent for how to craft an agreement that will help you meet your specific goals. “All these problems have been solved before. There's nothing new here."

The key thing to remember about operating agreements, Kaptzan says, is that they're only as good as their execution. “Having the rules is a start. Following them is another story."

Following the rules you create is the key to making your LLC operating agreement the business-enabling document it is meant to be.