Whenever you drive to a new location, a road map is a necessity. Without it, you risk making a wrong turn or getting lost.
The same goes for new businesses ― you need instructions that will guide your new business venture to its goal. For an LLC, that’s what a good operating agreement does. It sets your business up for success by outlining some important operational guidelines for your limited liability company.
Unlike some fill-in-the-blank forms, the operating agreement is a document you create from scratch. But if that sounds daunting, don’t worry. This guide will walk you through the process of creating your operating agreement.
Guru Tip: Most LLC services include an LLC operating agreement free in their more premium/expensive packages.
What It Is
The operating agreement is a document written by the LLC’s members for their own reference. The agreement details how the LLC will be run by setting out the roles, rights, and privileges of each member.
An operating agreement is a vital part of any LLC’s business records. The agreement is to an LLC what the bylaws are to a corporation. That said, an agreement is usually much shorter and easier to create than bylaws, as the LLC is a simpler business structure than the corporation is.
Why You Need One
Every LLC should draft an operating agreement. In a select few states, it is actually a legal requirement, although only New York requires LLCs to produce a written operating agreement.
Even if your state doesn’t require it, you’ll still want to write an agreement to keep your business running smoothly. The agreement can help settle disputes between your members ― when a disagreement occurs, your members can consult the agreement to clarify the rights and privileges of each member.
What about single-member LLCs? Perhaps you’re thinking that, as the only member, you don’t need to agree with anyone but yourself. While this may be true, we still strongly recommend that you draft an operating agreement that gives provisions for how new members can join the LLC, or what happens to your business if you pass away or are otherwise incapacitated.
You never quite know exactly how your business will grow. Setting up an operating agreement ― even if you think you don’t really need one ― will help make a transition seamless if and when new members join your business.
What It Contains
Every operating agreement should contain certain basic sections. While your agreement may vary a bit, the following information is almost always included in this document:
Basic business information: This may seem like a given, but your first section should list some basic information about your LLC, including the identities of your member/owners, and whether your ownership is distributed evenly or unevenly among those members.
You may want to include a mission statement, as this is a good way to make sure your members are all on the same page regarding your goals. You should also provide contact information for your business, such as your principal address and registered agent info.
Management: There are two forms of management commonly used by LLCs: member-managed or manager-managed. The member-managed LLC is managed by the owner or owners. This approach is best if you want direct control over the business affairs on a daily basis. Most entrepreneurs favor the member-managed LLC.
The manager-managed LLC takes some of the daily responsibilities of the business from the owners and assigns them to a separate manager. Instead of directly managing the LLC themselves, the members of the LLC appoint managers to oversee the day-to-day affairs.
Voting rights: If your LLC has multiple members, you should describe how the voting procedure will work. Most businesses have each member vote once, but if you have an unequal managerial structure where certain members take on more responsibilities than others, you may want to assign voting rights based on the involvement level of each member.
Capital investments: There are periods in any LLC’s life cycle (especially during the startup process) where your members will need to make financial contributions to your business. The operating agreement should define each member’s financial responsibilities to the smooth operation of your LLC.
Division of profits: The operating agreement also sets up how your profits are split. Much like with the capital investments, profits can be divided equally, they can be split unevenly to match each member’s investments and/or responsibilities, or using another method that works for you. What’s important is that you define this division in your operating agreement.
You should also include how the flow of profits would change if a member leaves or a new member joins. A large majority of business disagreements occur over money, so defining this ahead of time should alleviate potential tension between your members down the line.
Taxation: A key feature of an LLC is its flexible taxation ― you can elect exactly how your LLC will be taxed. The vast majority of LLCs are taxed as a pass-through entity ― meaning taxes aren’t paid on the corporate level, but instead pass through the business itself to its members. In certain circumstances though, it can be advantageous to have your LLC taxed as a corporation. Regardless of which option you choose, you should record the decision in your operating agreement.
Membership provisions: As your business grows and changes, you may want to add or remove members. Your operating agreement should describe how that process unfolds. For example, your members may vote to add or remove a member, with a majority or unanimous vote necessary to pass.
Dissolution: In the beginning of your business venture, you’re hoping for a successful launch. However, it’s important to make provisions for how to dissolve your LLC just in case. You’ll also want to set up how the LLC’s remaining assets would be divided among the members once you’ve dissolved.
Amendments to the agreement: When you first draft your agreement, it should fit your business perfectly. But over time, your business will change, and your operating agreement may need to change as well. New membership or a big increase in the size of your LLC could make your agreement out-of-date.
That’s why one of the closing sections of the agreement should include the procedure to change the agreement itself. The agreement should be semi-permanent (you don’t want to make spur-of-the-moment changes), but flexible enough that you can adapt it as the business evolves.
Other rules: Each business has unique needs, so the above sections might be insufficient. Your LLC’s members can add sections as needed. For example, you may want to include sections about the process for holding membership meetings, or regarding how the LLC’s banking needs will be handled. You know your business best, so if there’s a unique feature to your business, you should establish procedures for it in the operating agreement.
What Happens If I Don’t Use an Operating Agreement?
As we mentioned earlier, only one state (New York) actually requires LLC owners to produce a written operating agreement. So, in nearly all states, there are no legal ramifications for not having an operating agreement.
Still, we think every LLC should have an agreement, simply because it forces you to think through several important aspects of your business structure, and also helps avoid disputes between members.
If you don’t have an operating agreement, some elements of your business may be left open to interpretation, and uncertainty is never a good thing in this regard.
How to Set Up an Operating Agreement
Since the agreement is such an important part of your business, the process of drafting it is no simple matter. Fortunately, you have several options for this step. For one thing, you can use a template. Online business services (like ZenBusiness and LegalZoom) offer templates that you can download and fill in. Some templates are even free, and you can add or delete sections as needed. The template takes out some of the guesswork.
Another option is to hire a business lawyer. Your members and the lawyer can sit down and talk through your business plan. Armed with this information, the attorney can write the perfect agreement for your LLC. This option will surely cost more, but you can be confident that your agreement is appropriate and comprehensive.
You can always draft the agreement yourself, too. If you choose this option, it’s highly recommended to read a few sample agreements or at least browse the templates. Then you’ll have an idea of what your agreement should look like, including what language to use.
Once your agreement is drafted, you are not required to file it with your Secretary of State ― you can simply add the agreement to your business records.
Conclusion
Drafting an operating agreement for your LLC can be tricky, but it’s well worth your effort. The agreement is your road map to success and smooth operation, and without one, you’re leaving the door open to potential disputes between your members, or confusion regarding how your business should be run.
Guru Tip: Haven’t incorporated a business yet but you’re ready to get started? There are a handful of company incorporation services that can launch your business and register with the state. Northwest Registered Agent and ZenBusiness are two common choices for entrepreneurs.