What is an LLC operating agreement, and do I need one for my LLC? A guide for new business owners about the purpose, pros, and cons of an LLC operating agreement and the process of setting one up
Starting a new small business can be an exciting — and intimidating — endeavor, and it is vital to set the stage correctly. For many small business owners, that means forming an LLC and creating an operating agreement to avoid personal liability, legal burdens, and financial obligations.
This article provides basic information about operating agreements and answers some commonly asked questions to help you decide if your LLC needs an operating agreement.
Operating agreement definition
An operating agreement is a basic legal document agreed to when someone forms a limited liability company (LLC). At a high level, it sets forth the structure, management, decision-making process, and operating procedures for an LLC. An operating agreement is invaluable in laying out how the LLC is arranged, how it will be run, and how it goes about its work. Essentially, an operating agreement is a contract; once signed, the LLC members are bound by its terms.
What is included?
Operating agreements spell out a company’s operational and financial rules and provisions. Think of them as a how-to guide for how the business should be operated and managed. Specifically, an operating agreement should include:
- Portion of members’ ownership, often expressed as ownership percentages
- Powers and duties of managers and members
- Distribution of losses and profits
- Member duties and member benefits
- How board member meetings will be held
- How new members are to be admitted
- Voting rights
- Buyout and sellout processes — ownership transitions
- Tax considerations
- Transfer provisions
These are the basic components of an operating agreement. It does not have to spell out everything step-by-step, but the more comprehensive and specific it is, the better it is. One thing to remember here is that a key benefit of an operating agreement is its interplay between providing formal structure while simultaneously leaving room for flexibility so that it functions well for a specific LLC. That being said, these key elements will be present in any well-drafted operating agreement.
What are the pros and cons?
The major pros of an operating agreement are that it protects an LLC’s members from the liabilities of the LLC itself, enhances clarity in how the organization is structured and run, and provides flexibility in that it can be adapted to a specific LLC.
The cons of an LLC are far less significant and include expense, increased formality, and greater administrative duties. Most would agree that operating agreements have considerable upside and minimal downside.
The main benefits of having an operating agreement for your LLC include:
- Shielding LLC members from liability. With no operating agreement in place, there is a risk that the organization could resemble a sole proprietorship. The danger here is that the owner of a sole proprietorship does not enjoy the protections that stem from the organization being recognized as a distinct legal entity and so could be held liable for obligations incurred by the organization. That may mean a business owner’s personal assets are at risk of being used to satisfy the organization’s debts.
- Establishing clarity. With an operating agreement in place, everyone knows the rules, which can make day-to-day and significant decisions easier to make. It can also reduce the chances of dispute later in the LLC’s life.
- Providing room for customization. An operating agreement can be tailored to the specific needs of an LLC. It is not a one-size-fits-all document that an LLC must contort itself to comply with; rather, it can be adapted as the needs of the LLC dictate.
- Averting default rules. Without a signed LLC agreement in place, there is a chance your state’s default rules will govern your organization. This opens you, the business owner, up to risk — this stage of getting your business up and running should be all about minimizing risk and setting yourself up for success.
There are very few downsides to having an operating agreement for your LLC, and anyone would be hard pressed to argue that they outweigh the upsides. Even so, it is essential to recognize that the very few drawbacks to having an operating agreement would include:
- Creating extra expense. Developing and implementing an operating agreement does require an outlay of at least some capital, although the pricing can vary and is often considered money well spent.
- Crushing entrepreneurial spirit. Sometimes, there can be some resistance to operating agreements in the heady early days of a startup because some hard-charging entrepreneurs balk at the idea of formality or added structure. Implementing an operating agreement can feel like a step toward stodgy conventionality. Handshake and verbal agreements are no substitute for written operating agreements, however. Even if it goes against the grain of company culture, an operating agreement is still a good idea.
- Increasing formality. The formalities and requirements of an operating agreement may generate a little resistance from LLC members, and updating or amending it takes further effort and possibly capital outlay. It bears repeating that the benefits of an operating agreement most likely make this a price worth paying.
Few people would even try to argue that any possible downside to a written operating agreement would amount to sufficient reason for your LLC not to have one. However, an operating agreement is not the only formation document a business owner should know. Certificates of formation are another vital document, as are bylaws — even though they are for corporations and not LLCs.
Is an operating agreement the same as bylaws?
No, operating agreements and corporate bylaws are not the same. While there are parallels between these two types of documents, they govern different kinds of organizations and pertain to different aspects of running the organization.
- Operating agreements are an instrument for LLCs and focus primarily on ownership, management, and financial matters.
- Bylaws are rules and regulations that govern corporations’ internal operations and management, including non-profit corporations. They spell out how the organization will undergo its affairs; make decisions; and engage with its members, shareholders, and board of directors. Bylaws are more rigid than operating agreements and are usually not filed with a government entity or made public, although some jurisdictions require them to be kept at the principal place of business and be made available to shareholders or regulators.
Is an operating agreement the same as a certificate of formation?
An operating agreement is not the same thing as a certificate of formation. A certificate of formation — sometimes called a certificate of incorporation or articles of organization — is a simple legal document required to be filed with the appropriate state agency, usually the secretary of state, upon LLC formation.
A certificate of formation usually contains basic information like business name, business purpose, management structure, amount and type of stock, principal office, and registered agent. This designated person can receive legal documents on behalf of the LLC. Certificates of formation are where you would specify whether you have a member-managed or manager-managed LLC. States require these to know who is doing what kind of business and who is responsible for that business’ affairs.
The main differences here are that a certificate of formation is a legal requirement and a public document. In contrast, an operating agreement is not a legal requirement and, as an internal document, is not public.
How to know if you need an operating agreement for an LLC
Operating agreements are not necessarily needed or legally required for setting up or operating an LLC. Some states require LLCs to have a written operating agreement, including California, Delaware, Maine, Missouri, and New York. Since California, Delaware, and New York are three of the most important business states in the country, this signals that written operating agreements have great value. However, before you — the business owner — start making business expenses, hiring staff, and marketing your product or service, you should have your operating agreement in place. Here is why:
- Enhanced clarity. An operating agreement for an LLC provides clarity for everyone involved. It usually does not spell out every right and responsibility, but it does not have to. Providing a robust, overall look at who does what and why gives all parties a strong, foundational understanding of what is expected of them and what privileges they may enjoy.
- Reduced potential for friction. If an LLC has more than one owner, the operating agreement serves as a neutral point of reference that can reduce the possibility of friction further down the line. By setting out basic governing principles, the agreement can help co-owners conform their conduct to what is expected of them and reduce the potential of a dispute.
- Increased liability protection. Operating agreements reinforce the limited liability protection of an LLC. Because they delineate the LLC as a separate legal entity and define its adherence to corporate formalities, they can protect members from personal liability for the LLC’s legal obligations and debts.
The best time to create and implement an operating agreement is when you form the LLC because you want to clarify everything at the outset. While it is possible in many jurisdictions to create an operating agreement at any point during the life of the LLC, it is hard to formally capture and memorialize everything that has happened to date and, once again, having operating procedures set in place from the get-go makes running the business easier. That is less true if there is a period without an operating agreement and a period after an operating agreement has been put in place.
There are single-member LLCs and multiple-member LLCs. While it may seem like your single-member LLC should be a simpler affair than a multi-member LLC, all of the advantages of having an operating agreement — protection from liabilities, clarity, and flexibility — still apply. Remember, if you have chosen to be a single-member LLC, there is a reason you went that route instead of forming as a sole proprietorship. Do not risk being seen as a sole proprietorship by having no operating agreement.
Formal steps recommended to set up an operating agreement
It may be useful to discuss what degree of formality is required in an operating agreement.
- Do operating agreements need to be notarized? In most jurisdictions, it is not a legal requirement that an operating agreement be notarized. However, having a document notarized is neither difficult nor expensive, so it may be a good idea.
- Do operating agreements need to be filed with the state? No. In most jurisdictions, it is not a requirement that operating agreements be filed with the state — but certificates of formation or articles of incorporation do need to be filed with the state.
- Are operating agreements public record? No, operating agreements are not public record. They are an internal governance document that does not need to be filed with anyone. In fact, the U.S. Small Business Administration recommends they be kept confidential.
Creating an operating agreement for an LLC
Operating agreements can be created in a number of different ways:
- You write your own operating agreement. It takes knowledge of business law in your relevant jurisdiction and experience drafting operating agreements to prepare a good one. To make it easier, there are software programs that provide multiple variations of operating agreements — drafted by attorneys — that can be customized to your specific needs. Regardless, the final version should be reviewed by a lawyer.
- You hire a lawyer to create an operating agreement. Given the risk of getting into financial and legal trouble, it would be money well spent to hire a lawyer. It is not very expensive and might take two to three hours to draft a simple agreement.
- You use an operating agreement template. Template examples of operating agreements can sometimes be found on websites for secretaries of state, and many small business resource centers or business schools have templates available.
5 easy steps to set up an LLC operating agreement
If you have decided that an operating agreement is a good fit for your LLC, here are five steps you must follow to set it up:
- Learn your jurisdiction’s requirements. Operating agreements are largely a creature of state law, so you must understand what — if any — state-specific requirements apply to your operating agreement. There may not be any, but it’s better to know for sure.
- Gather need-to-know information. First, you must collect essential details about your LLC, such as who the owners are, their initial contribution, and what percentage each owns.
- Create a blueprint of structure and rules. Next, you should define your LLC's ownership and management structure, spell out profit allocation, delineate decision-making procedures, and list management responsibilities.
- Address key provisions. Your operating agreement should address matters like capital contributions, profit distribution, the process for adding and removing members, dispute resolution, and dissolution procedures. Remember, the point of an operating agreement is to establish the rules of the game, so to speak, so you want to make sure your operating agreement speaks to the most significant issues your LLC will face during its lifespan.
- Sign and keep copies. Once your operating agreement has been drafted, have all the members review and sign it. Notarization is not a legal requirement in most jurisdictions, but is a good idea. Keep copies on hand for ease of reference and legal protection.
Bear in mind that a major advantage of operating agreements is that they are flexible documents that can be adapted to suit the specifics of your LLC, so the five steps above are general and not comprehensive.
Ideally, this article has given you a good understanding of what operating agreements are, why they are useful, and why having one for your LLC is almost certainly a good option. When you are getting a new business off the ground, it is quite easy to mentally skip ahead to a time when your LLC is flourishing. You have to establish a solid foundation before you can get to that stage, though.
Having an operating agreement in place will protect you from personal liability and the financial obligations of your organization, keep relationships with other members smooth and professional, and help guide your LCC from its starting point to success.
Additional LLC operating agreement resources
Practical Law’s startups and small businesses collection has material you may find useful to support your business at every stage, including insights on hiring, funding, and scaling your business.
An LLC Operating Agreement Checklist is a checklist compiling questions to consider before preparing a comprehensive limited liability company agreement.
LLC Operating Agreements Line by Line is a book with a comprehensive explanation of the material provisions and issues that arise among limited liability company members when preparing or amending an operating agreement.
Structuring and Drafting Partnership and LLC Agreements, Fourth Edition is a book that provides expert guidance on every aspect of crafting tax-driven agreements associated with partnerships and LLCs.
Limited Liability Companies: Law, Practice, and Forms, 2d is a book with CDROM that optimizes the flexibility and tax advantages of limited liability companies and helps analyze planning issues.
Check out multiple versions of Practical Law operating agreements, including agreements for single-member, joint-venture, and multi-member LLCs