Imagine this: you successfully form your LLC, but as you begin conducting business, the members start feuding over share percentages, banks don’t take you seriously, and you’re slapped with lawsuits that threaten your personal assets.
Not a pretty picture. What you’ve just imagined is a very real scenario for an LLC that fails to adopt an operating agreement.
It’s true that only a handful of states actually require the creation of operating agreements by law, but it’s also true that drafting an agreement provides some essential benefits for any LLC, and we strongly recommend it.
An operating agreement acts, in many ways, like your LLC’s bylaws, setting up a framework of rules and regulations necessary for the company’s stability and success. Not only that, but it also details the LLC’s managerial and ownership structures, so that everyone within the company is on the same page and outside entities like courts and banks recognize its legitimacy.
The biggest advantage of having an operating agreement is the fact that it avoids leaving important aspects of your company open to interpretation down the road. Plus, it draws lines between your personal and business assets, creating a safety net in potential future legal disputes.
Want a closer look at what your state says about LLC operating agreements? Check out our step-by-step state guides below on what to include.
Which States Legally Require LLC Operating Agreements?
Considering the operating agreement’s importance, it’s surprising that more states don’t require it. As of right now, only five states legally require LLCs to have an agreement in place: California, Delaware, Maine, Missouri, and New York. And of these five, only New York requires it as a written document; the other four accept oral agreements as valid.
But don’t let the states’ lax stance on operating agreement fool you. This document is vital to your LLC’s livelihood, so we highly recommend maintaining one, whether it’s a legal requirement or not, because it can save you a tremendous amount of hassle in the future.
Which Type of LLC Operating Agreement Do I Need?
Now you may be thinking “so not only do I need to navigate this complicated document, but there are different types too?” Don’t worry, there are only two: one for single-member LLCs and one for multi-member LLCs, and there’s considerable overlap between the two.
A single-member LLC is fairly self-explanatory. In short, you are the sole owner of the company, and you don’t have any co-owners, business partners, or employees. If your company consists of you and only you, an operating agreement might seem like a waste of time. After all, why do you need to establish processes and conduct for yourself? For single-member LLCs, the operating agreement isn’t primarily to establish procedures, but to create a legal distinction between your business and you as an individual.
Your LLC serves as a shield for your personal assets. It will shelter them from creditors in the event that your business gets sued. By creating an operating agreement, you’re distinguishing it from yourself as a completely separate entity with separate assets in the courts’ eyes. Further, you’re spelling out how these business assets will be distributed after its dissolution or if you cannot run it any longer.
An operating agreement for a multi-member LLC will contain much of the same information, but with slightly different goals. It will designate whether your LLC is “member-managed” or “manager-managed” – a distinction that we’ll go over in detail below. Plus, a multi-member operating agreement should explain owner financial contribution procedures, decision-making processes, profit distribution, member conduct and replacement, and dissolution procedures.
What Information Should I Include in My LLC Operating Agreement?
Most states don’t provide an official operating agreement form, so you’ll need to create one yourself.
As you sit – staring at a blank page, cursor blinking – the big question is “where do I start?” Our suggestion: start by writing out some notes about the necessary information for your LLC. Then, you can use those notes to draft an effective agreement. Here’s what every operating agreement should include:
This is the nuts and bolts of your LLC, some of its most basic information, like where and when it was formed, as well as a description of the ownership group. It should clearly answer the following questions:
- How many owners are there?
- Who are these owners?
- How is the membership distributed?
- Is it an even split among the members?
- Are there varying levels of ownership for different members?
Remember the single-member vs. multi-member discussion from just a few paragraphs ago?
This section is where your multi-member LLC can designate its managerial structure, whether it’s managed by members/owners or outside managers. Choosing a member-managed structure will hand all daily managerial responsibilities to the owners, so be aware that you may end up with additional responsibilities if you choose this route.
If you’d rather delegate those responsibilities, you can hire managers from outside the company. This route is less common but may be better for your business if the owners are often caught up handling other pursuits, or if you simply don’t want to oversee the company’s daily minutiae.
Any group of people working together needs a simple, effective way to make joint decisions. As your business progresses, you will, no doubt, have important choices to make, and you’ll need to determine the best method for achieving a consensus among members. Your operating agreement should outline voting procedures so that there’s no confusion or discrepancies as to how decisions will be made.
The most common (and easiest) method is to give each member one vote. But you have plenty of flexibility with how you weigh these votes. For example, you can assign more or fewer votes to each owner based on their level of involvement with the company. You can also designate where, when, and how these votes will take place to ensure consistency.
Whether it’s in the startup phase, the growth phase, or any other period in your limited liability company’s lifecycle, there are times when it will require capital contributions from your owners.
Money can be a sensitive subject and trust us, there’s nothing worse than quarreling over it with your co-owners. So, make sure that your operating agreement contains detailed instructions for all of the LLC’s contribution procedures, putting everyone firmly on the same page.
Speaking of money quarrels, if you think it’s awkward to argue over contributions, just imagine a disagreement over how everyone gets paid.
Crystal clear guidelines for how each member and/or manager will be compensated are essential to maintaining contentment and harmony in your LLC. You can divvy up your income evenly, or you can outline an uneven split, perhaps to line up with each member’s contributions and/or voting rights. While some operating agreement sections are optional, this one is vitally important to your company’s well-being.
As your LLC grows, evolves, and changes, members may come and go, so it’s important to determine how you will add, remove, and replace them.
Even if you run a single-member LLC, you may bring on additional members in the future, or you may transfer ownership at some point, so this section is still necessary. If you fail to designate procedures for member replacement, there are some states that will actually dissolve your LLC if an owner leaves the business.
Outlining member/manager conduct requirements is another good addition. Even though you hope it never happens, you may need to dismiss one of your partners from the company. Having a carefully-outlined code of conduct will not leave this decision up to your subjectivity and could prevent disputes.
Dissolving the Company
Unfortunately, not every business lasts forever. Sometime in the future, you might find your LLC facing dissolution and, even though you might not want to think about it, you should have your process outlined and ready.
You might be understandably wistful or disappointed when closing your LLC’s doors, and at that point, having a set of dissolution steps ready to go will help make the process easier. These steps can also designate how the LLC’s remaining assets will be distributed – otherwise, the state will distribute them for you, potentially not the way you’d prefer.
It should also be noted that some LLCs only ever intend to be in business for a short while, and in that situation, having dissolution plans in your operating agreement is a can’t-miss step.
Additional Sections (Optional and/or Unnecessary for Most LLCs)
Consider this your free space, where you can set guidelines for any other aspects of the LLC that you’d like, as long as they don’t contradict state or federal laws.
Businesses that operate in specialized industries, for example, might have unique processes or regulations to follow. Or, you may want to declare specific meeting locations, designate who controls the LLC’s accounting, lay out certain employee rules, etc. Most LLC operating agreements will only need the sections listed above, but it never hurts to add more information.
How Should I Create My LLC Operating Agreement?
Now you’re ready to climb the operating agreement mountain, but don’t worry! There are a lot of resources out there that make it much less imposing.
Many LLC organizers choose to draw up the document themselves. If you take this route, there are plenty of online templates that can serve as a great jumping-off point, ensuring a solid organization and structure for your document. Most of these templates provide a great end product, but we recommend this one from Northwest Registered Agent.
If drafting an operating agreement is too daunting, or if you’d feel more comfortable letting a professional handle it, you can hire an attorney or enlist the help of an incorporation service like ZenBusiness or LegalZoom, who will also form your LLC for you. Hiring an attorney is the safest route but also the most expensive, and if you’re on a strict startup budget, it might not be feasible.
In almost every state, the operating agreement is an internal document, so you won’t need to file it with the government. Simply have your members or managers sign off, then store it with your other business records. In any of the five states that require operating agreements (listed above), check with the state government to see if there are any unique filing procedures.
What If I Go Without An Operating Agreement?
The short answer: don’t. The long answer: running your business without an operating agreement means it will be subject to your state’s default laws, baseline laws that dictate processes for everything that would normally be included in a custom agreement.
It might not seem like a bad thing to fall back on state’s pre-written rules, but consider this: the state legislature wasn’t thinking about your unique business when they drafted the default laws. Instead, they wrote vague statutes that could apply to any business at all. Consequently, these laws don’t have your LLC’s best interests in mind. Do you really want the state to determine how your company distributes its income, or what happens to its assets after dissolution? Probably not.
As stated earlier, your operating agreement also separates your LLC from you as an individual. Without one, your personal assets might be fair game if your business gets sued.
All that to say, the operating agreement isn’t just an annoying step in the LLC formation process; it’s an incredibly important document that will set your business up for efficiency and achievement. Hopefully, you’ve already considered some of the choices posed here, but if you haven’t, there’s still time! Just make sure you’re not ad-libbing it as you go along.
As you ponder your LLC’s framework and conduct, take a look at our in-depth operating agreement guide for your specific state and you’ll find information that’s even more pertinent to your circumstances. Once you have an operating agreement in place, your LLC will be ready to take on the world, primed for many years of future success.