An LLC operating agreement should be seriously considered if your business organization requires you to navigate the challenging, unpredictable, and overlapping waters of law and business.
When starting a limited liability company (LLC), this agreement is the foundational factor that points your business organization in the right direction.
Documenting this agreement is a surefire way to ensure full compliance with the latest business and legal regulations in your state and beyond.
Read on to find out what an LLC operating agreement is, how it works, and what it should include.
LLC operating agreement defined
A limited liability company is one of the most popular business structures for a variety of US business organizations due to the level of protection from liability that it provides for small businesses.
An LLC operating agreement is an official document that sets a business organization’s terms and conditions according to its members’ unique needs. It outlines the hierarchy for both functional and financial decision-makers.
Although it’s not mandatory to have this document in most states, it’s a crucial layer of protection for setting up an LLC.
Each organization member must sign the document and agree to the said terms. It is a legally binding document requiring every business member to adhere to a specific set of rules. This document allows business owners to specify their own rules for managing internal operations and affairs.
If you don’t draft an LLC operating agreement, your LLC will have to operate according to the default business rules of your state. An LLC operating agreement defines how many members a company has, how it handles taxes, who can sell shares, who can share in profits, and more.
How it works
An LLC operating agreement works by clearly identifying the following elements:
- Your business organization;
- The structure of your company;
- Your company’s ownership;
- Member duties; and
- Structural features of your organization.
Since it’s a legally binding document, it includes basic information about the owners (members) of an LLC. It also determines how a business should handle specific procedures, including the organization’s tax treatment.
We can define LLC operating agreements as legal contracts between/among business owners or members of multi-member companies. These contracts clearly outline the things that every member can or can’t do and lays down guidelines for handling certain vital operations.
A business can choose to keep an agreement confidential or public by providing proof of an existing document. If any disputes arise, members reserve the right to make changes and updates to the existing LLC operating agreements.
An LLC operating agreement also works by protecting your business organization from:
- Personal liability – the company is a separate entity from the owners, and each member possesses clear power limits and responsibilities;
- Financial liability – outlines who is responsible for financial management and company money;
- Trade secret sharing – determines the level of protection and control over intellectual property; and
- Conflicts of interest – defines potential conflicts of interest and how to mitigate them.
What should it include?
The general LLC operating agreement format includes the following elements:
- The percentage of each member’s ownership;
- The voting rights and responsibilities of each member;
- A framework of legal powers and duties of members;
- The allocation of profits and losses among eligible members;
- The rules regarding voting and holding meetings;
- The LLC management issues and how to resolve them; and
- Buy-sell and buyout provisions if a member wants to sell their company shares or leave the organization (member’s death included).
This document should also lay out the guidelines and definitions of specific terms in the operating agreement.
Finally, a legal contract should outline the purpose of the company, its location, the period that it intends to operate, preferable taxation options, optional member management, and a statement of its intent to form.
A legal contract such as an LLC operating agreement offers you control, protection, and freedom to manage your business operations however you see fit.
Operating agreement sections
You should include six essential sections in an LLC operating agreement.
Let’s quickly review all of them.
1. Organization
The first section of an LLC operating agreement should contain basic information about the business organization. It defines and solidifies the most basic and critical premises and decisions.
Typically, this includes the official name of your LLC, its location or place of operation, its duration, the ID of the company’s dedicated registered agent, its statement of purpose, and its management structure.
2. Management and voting
Both managers and members can manage an LLC. If you opt for managers, you should include the appointment of managers in your LLC operating agreement, procedures and terms for manager replacement and removal, responsibilities and duties, and the frequency and nature of voting and meeting procedures.
An LLC operating agreement also determines how members may vote. Typically, their voting rights match their percentage interests. You can use capital accounts, commitments, and contributions to determine voting and veto rights.
3. Capital contributions
Each member receives a capital account. Their initial capital contributions determine their initial percentage interests. They can provide a capital contribution to the LLC through a promissory note, services rendered, property, or cash.
If a member decides to contribute something other than cash, other members reserve the right to negotiate the value of such capital contribution.
An LLC operating agreement also addresses the number of initial capital contributions and the need for potential future capital calls.
4. Distributions
An LLC operating agreement should set the default rule of proportionate allocation of distributions, losses, and profits among eligible members, providing them with specific economic rights to alter the allocation rules.
5. Membership changes
Members come and go, and changes in membership can be quite frequent among LLCs. That’s why this section of an LLC operating agreement determines the procedure for handling membership changes such as:
- Adding new members;
- Exchanging membership between new and existing members;
- Determining whether members have the right of veto in situations when other members decide to sell their shares;
- Member’s death;
- Member’s bankruptcy;
- Divorce between members;
- Member’s disability;
- Member’s voluntary withdrawal from a position; and
- Member’s expulsion.
6. Dissolution
This section reflects the best course of action for dissolving the LLC by determining the circumstances for dissolution and how to proceed with the organization’s affairs and assets.
Different types
There are four main types of LLC operating agreements. We’ll briefly explain all of them.
Protected series LLC
You can manage multiple assets or properties under one unified LLC. The best example is the Delaware series LLCs. If you form a series LLC in Delaware, you have the option to separate each asset or entity, or property.
The protected series LLC allows you to treat each property or asset as a separate entity.
Protected series LLC operating agreements give you the power to divide your LLC into distinct categories.
Each category gives you the power and freedom to:
- Own, manage, and control separate categories of properties or assets;
- Keep separate financial records;
- Run different types of business; and
- Protect each category from any financial risks associated with other series.
There are no series limitations regarding a Delaware series LLC. You also have two options for forming one: registered and protected series.
Multi-member Delaware LLC
A multi-member Delaware LLC is a multi-class business model that allows LLC owners to form LLCs by dividing eligible members into different categories or classes. Owners assign unequal duties and freedom to separate member classes.
They can also further structure each class into unique groups with variable voting, reporting, economic, and other rights.
A multi-member Delaware LLC structure comes with a multi-class operating agreement that LLC owners can customize to include the basic information on specific members and their designated responsibilities and rights.
Delaware LLC founders determine specific provisions and guidelines for all of the pertinent LLC particularities such as governance, responsibility, and power, according to the Delaware LLC’s freedom of contract.
A multi-member Delaware LLC allows you to specify each class that you wish to keep separate in the LLC operating agreement and define each group’s powers, privileges, rights, and the things they’re not allowed to do.
Multi-member LLC
Multi-member LLC operating agreements apply to member-managed and manager-managed limited liability companies.
The first scenario involves situations where members put themselves in charge of all essential LLC operations. They draft the multi-member LLC operating agreement that allows them to make decisions by voting according to their share of interests or per member.
This LLC operating agreement further allows them to make various customizations to the document by assigning unique, specific, or additional rights and responsibilities to each member.
They can also require specific members to accept certain duties and rights, as long as they don’t go against public policy or are illegal.
In manager-managed LLC scenarios, the operating agreement clearly defines the leader or leaders of the company operations.
The existing members reserve the right to select third-party managers who would run the company. However, these managers can’t be members themselves. Members are at liberty to pose any limitations on the selected managers and contract, appoint, or elect a manager for these positions.
Single-member LLC
A single-member LLC business structure doesn’t require an owner to draft a legally binding operating agreement. Still, most professionals advise you to sign and date this document, especially if you’re the owner (primary member).
There are guidelines and provisions that the primary member should include in a single-member LLC legal contract to ensure protection against any liability beyond what the liability protection state code already outlines.
A single-member LLC operating agreement is beneficial when the primary member dies or becomes incapable of operating the LLC.
Conclusion
An LLC operating agreement benefits your company in many ways. It protects your business operations against liabilities, ensures your status as a company, and limits the personal liability of your members.
It provides the foundation for fortifying central agreements between owners and members and sets the terms for the division of compensation, ownership, duties, rights, and more.
The LLC operating agreement also allows leaders to define vital business processes clearly and ensures full compliance with the state laws and regulations.
Finally, drafting an LLC operating agreement is a surefire way to add legitimacy to your company and depict your business as authoritative and trustworthy.