An LLC operating agreement, or Limited Liability Company operating agreement, is a legally binding document in the form of a private rulebook created by the members of such a company, where the business entity itself is responsible for its debts and obligations, not its members.
So, this legal document sets out the legal framework for a business structure like an LLC, outlining how it's organized in terms of founders, members, as well as their investments and shares, and lastly, how the company is intended to operate in general.
Understanding LLC Operating Agreements
An LLC operating agreement is a legal document that's generally optional to create. Only a few states require it to be submitted when forming a company.
However, since this document governs how the essential functions of the company will operate, the relationships between its members, as well as their relationships with the company itself, its creation is vital to ensuring its proper functioning.
The operating agreement is typically used during the establishment of a company, where its members agree on how operating procedures will function. This document outlines various procedures related to the company's operations, including decision-making processes, financial management, conflict resolution among members, and amending the company's actions.
Doing so clearly defines all aspects of the company's operations, as well as each member's role, rights, and responsibilities. This clarity proves invaluable in the event of disagreement, ensuring that everyone understands how the organization operates and what each person's rights and duties are.
This approach helps maintain a clear structure and function within the company.
This document concerns all company members and is tailored to the company's ongoing operations. It is an internal document not limited to LLCs and can be adapted to any organization. The parties involved can create an operating agreement for a non-profit organization or any business entity.
Therefore, throughout the company's progress and ongoing operations, this document ensures the proper organization of procedures and relationships within the company.
What Information Is Included In an Operating Agreement?
The most important information that is included in an operating agreement is divided into three sections, as follows:
General Information
This section outlines essential details about the company and its members.
Company Information. This includes the company's legal name, principal place of business, and date of formation.
Members’ Information. This part contains basic information about all LLC members, including names, addresses, and contact information. It also includes their ownership interest in the company, i.e., their right to own a company in percentages or units.
Financial and Management Structure
Here, the operating agreement addresses financial contributions, profit distribution, and management.
Capital Contributions. This part describes and estimates the value of property, services, intellectual property, and the amount of money that members contribute to the company.
Distribution of Profit and Loss. Members should establish the rules for distributing profit and loss among them, which is usually equivalent to their capital contributions. However, members can agree on different distribution terms.
Management Structure. This part outlines the rules concerning the company’s management. It determines whether the LLC will be managed by its members or external members and provides details on the LLC’s voting rights, duties, and procedures for discussing and deciding various issues.
Operational Procedures
This section covers ownership changes, company dissolution, dispute resolution methods, and amending the operating agreement.
Transfer of Membership Interest: The LLC operating agreement should specify the conditions under which ownership interests can be sold among members or third parties. It also sets the rules for buyouts if a member wishes to leave the LLC and the restriction on transferring LLC ownership.
Dissolution and Distribution of Assets: This part provides the steps if members decide to liquidate the company or if it is required by law. It also regulates asset distributions among members after liquidation.
Method for Resolving Disputes: Members should outline the methods for resolving disputes among them, such as mediation or arbitration (in case of major violations of the company’s internal acts). If this document does not address dispute resolution, members can amend the document and include such provisions or let the court decide the disputes.
Amendment Procedures: This part outlines the procedure for amending the operating agreement, which is necessary considering the company’s need to adapt to changes in business.
How to Create an LLC Operating Agreement
All you need to do to create a comprehensive LLC operating agreement is to visit our builder and follow these steps:
Step #1. Identify the Members
Start by listing the basic details about each member involved in the company, such as their full names, addresses, and contact information. These details are crucial, as members are integral to the agreement's implementation.
Step #2. Include Company Information
Then, provide information about the company—its official name, registered address, and the date it was established. If the company will operate for a fixed term, specify that as well.
Step #3. Outline Member's Contributions
Now specify each member's capital contributions towards the LLC. This step involves detailing the amount and nature of each member's contribution to the company's capital, such as money, real estate, equipment, or other kinds of contributions. You also need to define the ownership interests of each member.
Step #4. Specify Obligations
With the contributions clarified, outline the members' and other individuals' specific roles and responsibilities toward the company's operations and management. If there are multiple managers, clearly delineate their duties to avoid confusion.
Step #5. Define Profit Sharing, Compensation, and Expense Coverage
Next, establish how profits, losses, and expenses will be handled within the company.
This step includes outlining how profits and losses will be allocated among members. Additionally, specify if members will receive salaries for their work within the company. Also, address how the company's expenses will be covered as well.
Step #6. Detail Accounting Records & Taxation
To ensure financial transparency and compliance, establish procedures for maintaining accounting records by specifying the frequency and method of document review. Also, outline the company's tax responsibilities and procedures for fulfilling them.
Step #7. Describe Dissolution & Termination
Besides the reasons for dissolution outlined by state law, the parties can specify additional circumstances that will lead to the company's termination, such as member withdrawal, death, or incapacity.
Step #8. Detail Decision-Making Procedures
Here, the parties can specify special procedures or considerations for the decision-making process, like the required majority for different types of decisions.
Step #9. Address Confidential Information
Protect sensitive information related to the company's operations by specifying what information is confidential and outlining procedures for sharing this information with third parties through non-disclosure agreements.
Step #10. Incorporate Additional Information
Finally, the parties can include other relevant details—additional rules, regulations, or provisions—for the company's smooth functioning.
Pros and Cons of Making an Operating Agreement
Let's delve into the significant pros and occasional cons of making an operating agreement.
Pros
Pros of LLC Operating Agreement
Clarity and Organization: While state laws provide general rules and procedures for organizing a company, an operating agreement allows parties to specify and organize a company's structure in the way they think is best for its future progress and success.
Legal Protection: By documenting all the essential rules and procedures in this written agreement, the parties create a roadmap for how the company will function. This approach helps the members avoid potential misunderstandings and resolve disputes more efficiently.
Flexibility: Operating agreements allow parties to design ownership structures, profit-sharing plans, and management setups that suit the business goals and the members' preferences. This adaptability is crucial for staying agile and responsive to changes in the market or your company's needs.
Cons
Cons of LLC Operating Agreement
Time and Cost: Creating a comprehensive operating agreement requires dedication, takes time, and may require legal assistance, which can add to your startup expenses and prolong the start of business activities.
Limited Legal Requirement: While an operating agreement offers many benefits, it's not always legally required in every state. This lack of mandate might lead some to underestimate its importance, resulting in a rushed or incomplete document that doesn't fully protect the company's and its members' interests.
Is an Operating Agreement the Same as Bylaws?
We can say that operating agreements and bylaws belong to the same “family” of the legal entity's internal documents.
In some aspects, these two documents overlap, as both regulate the entity’s management structure, voting processes and meeting protocols, dispute resolution methods, and profit and loss distributions.
However, there are differences, primarily in their legal entity eligibility. An operating agreement is characteristic of LLCs, which are generally smaller business entities, while bylaws are like an operating agreement for corporations.
There is also a difference in their prevalence. While operating agreements are optional in most states, bylaws are required in most states as a necessary document when establishing a legal entity.
The differences in these documents also reflect the structural differences between LLCs and corporations. An operating agreement for a business entity like an LLC is much more oriented toward its members and their day-to-day operations, while bylaws regulate issues related to the board of directors and corporate officers, i.e., the CEO, CTF, and others.
Anyway, both legal entity types should have more efficient internal regulation, and these documents can help them achieve that.
Partnership vs. LLC Operating Agreement
Partnership and LLC operating agreements are legally binding documents that set the rules for running the business, dividing profits and losses, and how to resolve eventual disputes.
However, to understand them better, we need to explore the key differences between these two agreements.
First, they are used for different types of legal entities. Operating agreements are used for LLCs, while partnership agreements are used for partnerships, whether general or family-limited ones.
Second, an operating agreement protects LLC members by guaranteeing that the company cannot use their personal assets to pay off its debts, but only the company's assets can be used to service debts.
On the other hand, in a partnership, especially a general one, partners are liable for the business’s debts with their personal assets.
Third, there are differences in how these entities are taxed and the flexibility they have in choosing the method of taxation. So, an LLC can be taxed as a partnership, a single-member or multi-member LLC, or even as a corporation.
The partnership doesn’t have flexibility; they are automatically taxed as a pass-through entity, meaning the partners report all profit and loss on their personal tax returns and pay the business taxes.
3 Mistakes To Avoid When Making an LLC Operating Agreement
To ensure the effectiveness of an LLC operating agreement, avoid these three critical mistakes:
LLC Operating Agreement Mistakes
Failure to sign. Members simply cannot forget to sign an agreement. Without members’ signatures, the agreement isn’t considered valid and binding. So, double-check that every member has signed the document.
Ambiguous language. The language and terms in the operating agreement must be clear, precise, easily understandable, and strict. Using unclear language increases the risk that members won’t understand the intentions or general agreement point, which leads to confusion and inefficiency.
Not updating regularly. Business environments change frequently, as do laws and regulations. Failing to stay updated with these changes can result in agreement provisions conflicting with new regulations or becoming outdated. So, regularly updating the agreement is key to staying in line with state law.
Final Thoughts
Every organization strives toward its purpose, and anything that facilitates and enables more efficient and effective achievement of its goals benefits the organization. That's the exact purpose of an operating agreement: to establish a structured framework that enhances operational efficiency and facilitates goal attainment.
By creating this legal document, its parties provide an organized framework that not only streamlines operations and facilitates goal attainment but also instills a sense of security and confidence in the organization's processes.
Therefore, we can conclude that drafting an operating agreement ensures clarity on operational procedures, roles, rights, and obligations for all involved.
