Deciding between an operating agreement vs. bylaws is a crucial step when starting a business, as these documents will define the structure and operations of your chosen entity. Understanding their differences will empower you to create the right one, include its essential elements, and set up your business effectively from the start.
In this guide, we'll explore the purpose of operating agreements vs. bylaws, highlight their differences, and provide clarity to help you determine which best suits your business needs.
Let's dive in!
What is an Operating Agreement?
An operating agreement is a formal document that outlines the ownership structure, operational procedures, and governing rules of a limited liability company (LLC).
When forming an LLC, a common comparison is made between an operating agreement vs articles of organization.
The articles of organization are a mandatory document to legally establish a company, particularly in the form of an LLC. However, the operating agreement, another key LLC formation requirement, governs the mechanisms for regulating all internal operations.
Since an LLC operating agreement is an internal document, it is not mandatory, and there is no need to make it public like the articles of organization.
However, it is still highly recommended for all LLCs for several reasons.
First, it ensures that all members have a clear understanding of how the company is managed, the responsibilities of each member, the decision-making process, and how profit will be distributed among members.
By regulating internal rights and obligations, the operating agreement also reinforces the LLC’s status as a distinct legal entity, separate from its members, which is crucial for maintaining limited liability protections.
Finally, an operating agreement is a flexible document that can adapt to the business’s growth and changes. Members can modify it, update its terms, change its provisions, and align it with their evolving needs and state law requirements.
Who Needs an Operating Agreement?
An operating agreement is essential for all LLCs, whether they're multi-member or single-member LLCs. Multi-member LLCs benefit the most because it defines each member’s role, percentage of ownership, and decision-making process.
On the other hand, an operating agreement protects single-member limited liability status and demonstrates the separation between personal and business finances.
What Goes in an Operating Agreement?
An operating agreement for an LLC typically includes the following sections:
Operating Agreement Sections
Each member’s percentage of ownership
Whether the LLC will be member-managed or manager-managed
How profits and losses will be divided among members
Voting procedures
Procedures for adding members
Steps to dissolve the LLC
Mechanisms for resolving conflicts among members
Details of each member’s capital contribution to the LLC
What are Bylaws?
Bylaws are the official set of rules that outline how a corporation operates and makes decisions. They are drafted during the corporation’s formation and cover critical aspects such as the duties of directors, officers, and shareholders, as well as the rules of meetings, voting, and resolving conflicts.
The purpose of corporate bylaws is to ensure the corporation operates efficiently, is compliant with legal standards, and maintains transparency with its stakeholders. Similar to an operating agreement, bylaws deal with regulating the internal matters of the corporation to ensure its optimal functioning.
In this way, bylaws directly impact the relationship between the corporation and banks, investors, or legal authorities because they demonstrate that the corporation’s structure and operations comply with state and federal laws.
Who Needs Corporate Bylaws?
Bylaws are a requirement for most corporations, particularly those established as C or S corporations and with multiple stakeholders, as they ensure everyone understands their rights and responsibilities.
Also, bylaws are used by nonprofit corporations to show that they comply with tax-exempt status regulations.
What Information is Needed in Bylaws?
Bylaws generally include the following information:
Bylaws Sections
Structure and roles of the board of directors
Duties and responsibilities of officers
Procedures for shareholder and board meetings
Voting rights and processes
Issuance and transfer of shares
Conflict resolution mechanisms
Procedures for amending bylaws
Steps for dissolution of the corporation
Operating Agreement vs. Bylaws: What Are the Differences?
Understanding the distinction between an operating agreement vs. bylaw is essential, as both documents play a crucial role in shaping how your organization operates.
These documents clarify roles, responsibilities, and processes but are not interchangeable. That's why understanding the difference between bylaws and operating agreements is crucial to ensuring your business is structured correctly and legally compliant.
Operating Agreement and Bylaws Differences
#1. Ownership vs. Governance
An operating agreement centers on ownership—defining the rights, responsibilities, and ownership stakes of LLC members. It regulates ownership dynamics like profit sharing, decision-making authority, and how disputes are resolved.
On the other hand, bylaws focus on corporate management by establishing rules for how the organization operates, such as electing directors, appointing officers, and conducting board and shareholder meetings.
#2. Structure
The structure of these documents reflects the nature of the entities they govern. Operating agreements are flexible and allow LLC members to customize the documents to fit their specific needs and operating style. This flexibility reflects the less formal nature of LLCs.
In contrast, bylaws are more rigid, following standardized governance practices and adhering to state corporate laws, such as those outlined in Delaware’s General Corporation Law (DGCL), which is commonly applied to large, publicly traded companies.
The bylaws are also indirectly influenced by federal regulations, such as those by the U.S. Securities and Exchange Commission (SEC).
#3. Purpose
The primary purpose of an operating agreement vs. bylaws lies in their focus: the operating agreement is an internal agreement among LLC members regarding business management, profit distribution, and conflict resolution.
Bylaws focus on setting clear rules for the corporation's operations, including procedures for meetings, voting, and appointing directors and officers, to ensure consistency in corporate governance.
#4. Legal Requirements
The legal requirements for operating agreements vs. bylaws vary by state. While they are not always mandatory, having one is strongly recommended to prevent disputes and ensure clear guidelines for the LLC's operations.
Bylaws are a legal necessity for corporations, as they are typically required during formation, and failing to adopt them can lead to compliance issues and operation challenges.
#5. Applicability
The applicability of these documents depends on the type of entity being formed. Operating agreements are specific to LLCs, as they provide flexibility to meet the unique needs of their members. In contrast, bylaws are exclusively used by corporations to formalize their structure and governance.
#6. Amendment Procedures
Amendments to an operating agreement are typically straightforward and require approval by LLC members. This simplicity aligns with the adaptable nature of LLCs.
However, amending bylaws in corporations is a more formal process, reflecting the structured, rule-based corporate governance framework. Namely, the amendment procedure for Bylaws often requires the board of directors or shareholders to vote.
Who Can Create an Operating Agreement or Bylaws?
An operating agreement and bylaws are created by the members of an LLC or the board of directors and shareholders of a corporation. For LLCs, the members usually create the operating agreement when the business is first set up. In corporations, the board drafts the bylaws during the incorporation process.
While legal assistance isn’t required, it’s advisable, especially for more complex businesses, because a lawyer can ensure the document is legally correct and in accordance with state and federal law.
For those looking to create an operating agreement, Contacts.net offers an operating agreement builder that makes the process simple and efficient. With our builder, users can easily create a professionally and legally sound operating agreement without the need for expensive legal fees, which ensures that all essential elements are covered.
Why is it Important to Understand Governance Documents?
It is important to understand governance documents because they are the foundation for the creation and operation of any business, whether it is an LLC or a corporation. Governance documents are also used by non-profit LLCs, showing that, regardless of whether an organization has profit-driven goals, it requires a functional system.
Legal documents such as operating agreements, bylaws, constitutions, shareholder agreements, trust instruments, and others, which are types of LLC and corporate governance documents, establish and maintain a system in which everyone knows their rights, responsibilities, and the organization’s value.
Additionally, clear governance documents are essential for compliance with regulatory requirements, such as when submitting IRS Form 1023 for tax-exempt status.
Only when an organization has clearly and precisely defined rights, obligations, and procedures can it ensure that everyone within the organization is on the same page. This will reduce legal, financial, and management risks, fostering a well-organized structure that supports the success and stability of an organization.
Final Thoughts
By understanding the differences between operating agreements vs. bylaws, business entities can easily identify which document aligns best with their organizational needs. Choosing the right one ensures smooth business operations, clear procedures, and well-defined roles, preventing potential conflicts caused by a lack of clarity.
So, with proper organization achieved through these key documents, businesses can focus on what truly matters—achieving success, breaking into the market, building a strong reputation, and delivering quality.
Operating Agreement vs. Bylaws FAQ
You can write your own operating agreement if you’re familiar with LLC laws. However, consulting a lawyer ensures it’s tailored to your business needs and legally sound.
No, a shareholder agreement is not the same as an operating agreement, as the former is used by corporations and governs the relationship between shareholders. On the other hand, an operating agreement is specific to LLCs and outlines management structure, roles, and operating procedures.
Without an operating agreement or bylaws, your LLC or corporation will default to state laws, which may not align with your business preferences or needs.
No, LLCs do not have bylaws. Bylaws are for corporations, while an operating agreement is used by LLCs.
A single-member LLC should have an operating agreement because it proves the separation between personal and business assets.
