How to Create an Operating Agreement

One of the most attractive features of the limited liability company (LLC) business entity type is its flexibility. Unfortunately, many LLC owners aren’t taking full advantage of that flexibility when they fail to create an operating agreement.

An operating agreement has many advantages, one of which is tailoring the rules of an LLC to suit the needs and wants of its owners. Creating a document like this can be intimidating, but this article has some helpful tips on how to create an operating agreement for an LLC.

An operating agreement is a document LLC owners (called “members”) agree on to establish the rules of the company. It can cover a lot of ground, including ownership percentages, how profits are divided, how the LLC is managed, what happens if members leave or are added, and more. For more information check out Operating Agreement Definition page

Once the operating agreement is signed by all the members, it becomes a legally binding document.

How do I write an operating agreement?

The first step in writing an operating agreement is to decide what specifics you want to include, discuss them with the other members, and see what you can agree on. You’ll also want to research your state’s LLC laws to ensure nothing in your agreement is legally out of bounds.

You have choices in how you go about actually writing the agreement. Although you’re not legally required to do so, you can get a business attorney to draw one up for you. Then it’s just a matter of having all members read it over carefully and sign it.

Another option is to write one yourself or collaborate with the other members in writing it. Obviously, this can be riskier if you don’t have a lot of practice drafting legal documents.

Another approach some LLC members use is to find an operating agreement template and use that as the basis of their agreement. Then they either sign the document or have an attorney review it first.

Once the operating agreement is signed, put it in a secure location with your LLC’s other legal documents. All the members should have access to it. You don’t need to file it with any state agency, even in the states that require an operating agreement.

What do I include in the operating agreement?

You and the other members will have to decide what elements to include in your agreement according to your situation and wants. Below are some of the most common items covered in a well-written operating agreement.

Here’s what you need to include when you write your operating agreement:

Basic and Identifying Information

You’ll want to include the basic information about your business, including your LLC’s official name, the legal names and addresses of all the members, the principal business address, and the name and address (the registered office) of the registered agent.

You can also include a basic statement of purpose here broadly describing what types of products and/or services your LLC will be selling. If your LLC is meant to be temporary and only exist for a limited time or until a certain objective is reached, state that here, too.

Ownership Percentages

Although many LLCs divide ownership equally among the members, you may want to split them a different way. This is another area where having an operating agreement is critical.

If Mary, Larry, and Carrie want to start an LLC, but Mary is putting up 50% of the startup capital and Larry and Carrie are only putting up 25%, perhaps they want Mary to own 50% of the company. Without an operating agreement, the state may decide to divide the business’s assets equally among the members if the LLC dissolves, which isn’t very fair to Mary.

This section of the agreement is also a good place to list any capital contributions each member is making to the LLC, along with any equipment or other property. It’s good to have this in a written record.

Dividing Profits

In addition to specifying how much of the LLC each member owns, the operating agreement also needs to say what percentage of the business’s profits each member will receive. These percentages of profits are called “distributive shares.”

In most cases, members divide distributive shares according to ownership percentages. In the previous example, Mary would get 50% of the profits because she owns 50% of the business. But you can also make a different arrangement by writing it into your operating agreement.

For example, sometimes an LLC member wants to be a part of the company and contribute startup capital but doesn’t want to have to participate in the daily running of the business. In exchange for fewer responsibilities, that member could propose to the other members that they receive fewer distributive shares despite being an equal owner.

One note of caution: Sometimes arrangements like this set off red flags for the IRS. The IRS may see this as some sort of tax dodge shenanigans. To avoid trouble, you’ll need to follow the government rules for “special allocations,” which is the term used to describe businesses dividing profits in a way that doesn’t correspond to the owners’ ownership percentages. Consult a tax professional to ensure you don’t incur the wrath of the IRS.

Distributions

It’s not enough to say what profit percentage each member receives. You also need to specify when and how they’ll receive those profits.

As LLC members, ask yourselves how often you’ll each need to receive your profits share from the LLC. You’ll probably at least want enough to cover any income taxes you’ll owe on your portion of the LLC.

Do you need to make a schedule for making distributions to the members? Can they draw upon their portions at will? If they’re being distributed on a regular schedule, who in the company is responsible for making the distributions?

This is another area of the agreement where you may want an accountant’s advice.

Management Structure

Generally speaking, LLCs operate under one of two management structures: member-managed or manager-managed. You may have had to specify which management structure you plan to use in your Articles of Organization.

As the names suggest, member-managed LLCs are run by the members, who make decisions about the business on a daily basis. A manager-managed LLC is run by one or more managers. The managers can be LLC members who are appointed by the other members to serve as managers, or the members can hire a manager from outside the company ownership. 

Many LLCs choose to be managed by the members because they only have a few members or just one. In those cases, it usually makes sense for the LLC owner(s) to do member-management because they’re running the business themselves. All of the owners share in running the business and making decisions for it.

But some LLCs prefer to appoint or hire a manager instead. In the manager-managed option, one or more LLC members can be appointed to make management decisions, or someone from outside the LLC can be hired to manage the company.

Manager-management can be helpful when some of the members only wish to be investors in the company as opposed to running the business and making decisions about it. LLCs that have a lot of members often find it easier to have a manager because it’s difficult to get all the members together to make decisions.

When it comes to defining the manager’s authority, it’s wise to be very specific. For example, you might be okay with a manager making daily business decisions about inventory and more mundane issues, but you may want to reserve bigger decisions (such as hiring employees and bringing in additional members) for a vote by all the members.

Members’ Responsibilities

Let’s face it: Business owners are human. They’re more than capable of being lazy and otherwise shirking their responsibilities. People also misunderstand, misinterpret, and forget things like whose responsibilities are whose.

For those reasons, it helps to clearly define the responsibilities of all the members. Who will perform which tasks, and how often? Are certain members responsible for overseeing a particular aspect of the business?

Make sure you know what each member’s skills and capabilities are so that their assigned responsibilities are realistic. Take into account how much time each member has to contribute to the business, especially if they’re doing it as a side hustle instead of a full-time endeavor.

Meetings and Voting Rights

Unlike corporations, LLCs aren’t legally required to have regular meetings, but you’ll likely want to have regular meetings of the members to discuss the direction of the business and ongoing issues and make important decisions as a company. You can use the operating agreement to establish a time and place for these regular meetings.

When you do meet and have matters to vote on, it’s important to have established the voting rights of each member. Does each member have an equal vote, or, for example, do those with a greater ownership percentage of the company get more votes?

Your rules for voting could also vary by the issue. For example, a simple majority vote may be all that’s needed for less-important decisions, while bigger decisions, such as bringing on a new member, require a unanimous vote.

You’ll also want to establish how many members need to be present for there to be a quorum, as well as any allowances for voting remotely if a member can’t attend in person.

Adding and Removing Members

At some point you might find a new business partner who wants to join your LLC. Or, you may find you need to remove a member for some reason. In either case, you need to have a clearly stated policy to follow in your operating agreement.

If you’re adding a member, do all the other members need to approve the addition? Will new members be required to contribute a certain amount of capital to the company? Are there certain actions that would trigger the expulsion of a member? How many votes would be needed to remove a member?

Transferring Ownership

If a member wants to leave and sell their ownership of the company, what’s your policy? What if they wish to sell it to an outsider whom the other members disapprove of?

Many operating agreements have a “right of first refusal.” This means that the member wishing to sell must first give the other members a chance to buy their portion of the company before offering it to an outsider.

Transferring ownership of an LLC is more complicated than selling stocks in a corporation. You may want a business attorney to help you hammer out the details of this portion of the agreement.

Loss of a Member

Whether you’re a business owner or not, it’s important to make plans for the unthinkable. If a member dies or becomes incapacitated, what happens to their ownership of the LLC?

Business owners approach this in a variety of ways. For example, the other members could be given the opportunity to purchase the member’s portion of the LLC. The ownership interest could instead be inherited by a loved one of the deceased member.

It’s also possible to arrange for the beneficiary to inherit the ownership interest and the corresponding profits but not be allowed to participate in business decisions.

Financial Provisions and Procedures

You and the other members will need to determine how you want your LLC to be taxed (sole proprietorship, general partnership, C corporation, or S corporation). Once you do, you can record it in the agreement.

You can also specify other financial matters, such as what accounting method you’ll use and how records will be kept. Provisions like this help ensure everyone’s on the same page and thinking about these issues ahead of time.

Amending the Operating Agreement

The agreement needs to have clear provisions in place for how to amend it. Think about things like how many votes will be required to approve a change and who will be responsible for updating the document.

Dissolving the LLC

At some point, you and the other members may want to end the business. Legally closing a business is called closing a business. Your agreement needs to provide specific procedures for making that happen.

Does the decision to dissolve the LLC need to be unanimous or a simple majority of the members? Also, what happens to the business’s remaining assets once all of its debts have been paid?

Severability Provision

If you’ve ever read a contract, you may have seen a severability provision. It’s boilerplate language stating that, if a court finds one part of a contract invalid, the rest of the contract is still in effect. This prevents a minor error from rendering your entire operating agreement worthless.

Why should you have an operating agreement?

It’s surprising that only five states (California, Delaware, New York, Maine, and Missouri) legally require LLCs to have an operating agreement because — seriously — it may be your LLC’s most important document.

Here are some of the benefits of having a well-written operating agreement in place:

• Avoiding conflict: Going only by verbal agreements is rarely a good idea. You may remember something one way while the other members remember it differently.
• Further protecting personal liability: Yes, the LLC structure itself is supposed to protect the members from personal liability, but someone could still challenge the validity of your LLC in court to try to go after the member’s personal assets. Having an operating agreement in place makes your LLC look more legitimate in the eyes of the court.
• Avoiding default rule of the state: Without an operating agreement, your LLC will be governed by the state’s default LLC laws, which may not reflect your wishes.
• Showing it to other entities: Potential investors and others you plan to do business with may insist on seeing your operating agreement. Banks may require one before you open a business bank account or apply for a loan.

Recommended articles:

• Creating a Single-Member LLC Operating Agreement
• Creating a Manager-Managed LLC Operating Agreement
• How to Write Business Partnership Agreements
• How to Make an Equipment Lease Agreement

How We Can Help

If you’re not sure where to begin with writing an operating agreement, we have a operating agreement template that can help. It’s another way we help aspiring entrepreneurs start, run, and grow their businesses.