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An LLC operating agreement is a legal document that outlines the governing structure of the LLC, as well as the rights and responsibilities of each owner. An operating agreement isn’t legally required in most states, but it should be stored with other important business records.
When starting a new business, every entrepreneur wants to focus on their customers and providing the best product or service. But there are some legal matters that you need to take care of first to protect your business now and in the future. If your business entity is structured as a limited liability company (LLC), then you’ll need to create an LLC operating agreement.
An operating agreement provides a blueprint for running your business and lays out the rights and duties of each owner. Most states don’t require an operating agreement, but having one can help you stay focused when business gets tough and avoid conflicts with your business partners. We’ll cover why it’s important to have an LLC operating agreement, what to include in your agreement, and how to create one.
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In order to establish a limited liability company, you have to file articles of organization with the state. The articles contain basic information about your business and make it legal for you to operate in the state. However, there are additional compliance requirements, and depending on which state your business is located in, one of these might be the creation of an LLC operating agreement.
Five states—California, Delaware, Maine, Missouri, and New York—require LLCs to have operating agreements before the owners can sell any products or services. In these states, the agreement can be written or oral (in a few, it can even be implied by the behavior of the LLC members). Most don’t give too much guidance on what should be included in the agreement. We strongly recommend a written LLC operating agreement. A written agreement is the best way to document the business owners’ agreements and prevent misunderstandings down the line.
Even if your business isn’t located in one of these five states, it can be vital to your business’s success to have a written LLC operating agreement. We’ll explain why in the next section.
An LLC operating agreement is similar to a founders’ agreement. The agreement contains information that the members think is helpful to clarify now so that the business runs smoothly later on. But there’s more to it than that. The existence of the agreement also helps to cement the company’s status as a limited liability company.
Deborah Sweeney, CEO of MyCorporation, says, “Our company has an LLC operating agreement, and I believe it is extremely important in setting for our business ownership, roles, and structure. We leverage this document for use as a basis from which we update and make changes each year. The operating agreement can serve the purpose of setting forth how the business is run, cash distributed, roles maintained, and ultimately, how the business assets may be transferred or sold.”
Here’s more on the benefits of having an LLC operating agreement:
In order to preserve your LLC’s limited liability, you should document as many of your LLC’s processes as possible. It’s particularly important for a single-member LLC to show that the business is a separate legal entity from the owner. This helps ensure that legal claimants and creditors can only come after your company’s assets, not your personal assets.
In an S-corp or C-corp, the shareholders’ division of profits must match their ownership shares, but the LLC operating agreement gives you more flexibility to choose the rights of each owner. For example, let’s say Owner A contributes 70% of the money to the LLC, but does only 30% of the work. Let’s say Owner B contributes only 30% of the money, but does 70% of the work. You can set up your LLC operating agreement to give each owner a 50/50 split of the profits since they’re each bringing something different to the table.
An LLC operating agreement contains clear provisions about each owner’s contributions to the business, their share of profits, and their responsibilities to the company and other members. That means the agreement is a good dispute resolution tool. For instance, if marketing matters are entrusted to one member in the operating agreement, then that member gets the final say if any disagreement arises about a marketing strategy.
In the absence of an LLC operating agreement, your state’s default rules will kick in. Every state has adopted default rules on LLC management, admitting new members, dissolution, and other aspects of LLC governance. You might not agree with how your state has addressed each of these issues, but you need an LLC operating agreement to override your state’s rules.
In most cases, entrepreneurs want their business to continue after they retire or pass away. An LLC operating agreement clearly specifies who will take over your business, and on what terms, if you can no longer be at the helm. This can prevent inter-family squabbling and lengthy legal battles.
There are several issues you should cover in your LLC operating agreement, some of which might differ based on the industry your business is in and the specifics of your company’s needs.
Here are some of the issues you should be sure to cover in your LLC operating agreement:
To start, your LLC operating agreement should contain basic information about your business, including the legal name of the company, any fictitious business names/DBAs, the company address, and the registered agent who accepts legal service of process on your behalf. Every LLC must have a registered agent under state law.
Most LLC operating agreements include a line or two about the business’s industry and primary product or service. Usually, there’s also a line that permits the business to engage in any lawful purpose, giving the business freedom to pivot later.
Unless your LLC is set up for a specific project or time frame, like a joint venture for example, this section would include a brief statement that allows the LLC to continue in perpetuity.
By default, LLCs are taxed as disregarded entities. Instead of the LLC paying a business tax, each member reports their share of the business profits and losses on their personal tax return, which are taxed at the member’s personal income tax rate. LLCs can elect to be taxed as S-corps or C-corps by filing forms with the IRS. You should indicate your LLC’s preferred tax treatment in the LLC operating agreement.
Along with basic company information, your LLC operating agreement should also contain information about each member and manager. This includes each member’s name, address, title, job responsibilities, and ownership percentages. It’s possible to have a member-managed or manager-managed LLC. If member-managed, the members will collectively manage day-to-day business operations. If managed-managed, the members will elect a manager (from among their ranks or an external manager) to manage the business.
The LLC operating agreement should specific whether the LLC is member-managed or manager-managed. If it is manager-managed, the agreement will likely also specify the manager’s responsibilities, salary, and tenure of employment. The method for firing or electing a new manager should also be provided.
The LLC operating agreement should show what each owner has contributed to the business and the value of each contribution. Some members might contribute money, while others contribute property, skills, labor, intellectual property, or other resources. In exchange for their contributions, LLC members receive an ownership interest in the business. This ownership interest might, but need not be, equal to the percentage of capital that the member has contributed.
LLCs aren’t legally required to hold meetings in the same way that corporations must do for their shareholders and directors. However, most LLC operating agreements schedule periodic meetings to vote on important matters. The agreement should summarize the time, place, and manner of the meetings (e.g. can members join by video call, or must they attend in person?), as well as the purpose of each meeting.
Voting rights are closely related to meeting provisions because members usually take a vote on important decisions during meetings. Members in member-managed LLCs will have more opportunities for voting. The voting provisions should clearly outline the voting share of each member—it is usually, but not always, equal to the ownership interest of the member. You also need to specify whether a simple majority is sufficient to finalize a vote. In a manager-managed LLC, it should be clear when members must step in and approve manager actions.
Most business owners want the freedom to change their LLC operating agreement later if necessary. If you’d like this opportunity, you should specify the procedures for voting on changes to the operating agreement.
Member compensation depends on each member’s role within the business and the tax treatment that the LLC elects. If the LLC is taxed as a corporation, members can receive a salary for their work in the business, along with distributions. If the LLC is taxed as a disregarded entity, members will only receive distributions based on their ownership interest in the company.
There needs to be a process for admitting new members into your LLC and handling the exit of existing members. In most cases, admitting new members will require a vote and a meeting. You’ll also need to address what happens when a member wants to leave the business and sell their ownership interest. Must members sell to parties with specific qualifications? What if a member passes their ownership share to a family member who has no knowledge of business affairs? Most LLC operating agreements grant a right of first refusal to existing owners to purchase outgoing owners’ interests so that members retain close control over the business.
Lastly, the LLC operating agreement must address the possibility that members might want to someday dissolve the business. Usually, members must vote to trigger dissolution proceedings. Ending an LLC’s existence as a business entity can be a complex process that involves filing appropriate forms with the state, liquidating assets, paying creditors, and more. Members share assets that remain after all creditors are paid. The agreement should outline the wind down procedures.
Unless you are a lawyer or have a legal background, we don’t recommend starting from scratch when drafting your LLC operating agreement. Your LLC operating agreement is legally binding on you and all other owners, so you’ll want to make sure that it fairly reflects all the owners’ intentions.
If you have more than two members or a more complicated-than-average situation, then we recommend hiring a business attorney to draft your LLC operating agreement. Complex situations might include foreign transactions, one of the members being a business entity, or an LLC with a high volume of assets. Many lawyers will help you file articles of organization and write up your operating agreement for a flat fee. They will make sure that all the clauses relevant to your business are included and that the agreement complies with any state-specific requirements.
For simpler situations, small business owners might be able to put together an agreement on their own with the help of a template. Law libraries and legal help sites often have templates of operating agreements and other legal documents. LegalZoom goes one step further than a template and will walk you through the creation of your LLC operating agreement with a step-by-step questionnaire. The agreement will be customized to your state’s requirements.
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An LLC operating agreement sets the ground rules for your business for all owners to see. It’s the single best way to launch your LLC on solid footing and prevent disagreements among owners. An operating agreement also has the advantage of preserving each owner’s limited liability status. That can be important whether you have several members or a single-member LLC. Although creating an LLC operating agreement with a lawyer’s help is the most careful route, online legal services like LegalZoom can help you put your agreement together quickly and easily.