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What Is an LLC Operating Agreement?

LLC Operating AgreementAre you looking to form a limited liability company? The LLC is a highly popular business entity, and every day there are thousands of them formed from coast to coast. While the process for creating an LLC isn’t terribly complicated, there are quite a few steps ― some that are legally required, and some that are strongly encouraged ― that must be handled in an accurate manner.

One such step is the creation of an operating agreement for your limited liability company. While the operating agreement is only a legal requirement in a handful of states, it’s highly recommended for any LLC, because this document helps set down some rules and regulations for how your company will operate. This important document details the managerial and ownership structures of your LLC, as well as some other crucial details.

The biggest advantage of having an operating agreement is the fact that it helps avoid leaving important aspects of your company open to interpretation down the line, which can also enable you to avoid potential legal issues. This article will outline the two different kinds of LLC operating agreements, as well as discussing the information that’s usually included in them. Let’s get started!

 

Which States Legally Require LLC Operating Agreements?

Limited liability companies are required by law to have operating agreements in California, Delaware, Maine, Missouri, and New York. However, of these five states, New York is the only one that requires it to be written down, whereas the other four all allow for operating agreements to be oral agreements.

We think it’s absolutely crucial that any LLC in any state have a written operating agreement, whether it’s a legal requirement or not. It’s a simple document that doesn’t take too much time or effort to create, and it can save you a tremendous amount of hassle down the road.

 

Which Type of LLC Operating Agreement Do I Need?

While there is quite a bit of overlap between the two, the style of operating agreement that will best suit your limited liability company depends on whether your business is a single-member LLC or a multi-member LLC. There are some ways in which these different types of LLCs lend themselves to differing styles of operating agreements, so let’s outline what exactly these contrasting elements are.

With a single-member LLC, you are the sole owner of the company, and you do not have any employees. It might seem like a waste of time and effort to draft an operating agreement if you’re starting a single-member LLC, but it’s important primarily because it helps create a legal distinction between your business and you as a person.

Why does this matter? One of the main reasons to form an LLC in the first place is because it provides personal asset protection, which means that if your business is sued, the LLC business structure will help shield your personal possessions and finances from creditors. One of the most common ways a single-member LLC owner can lose this personal asset protection is if a court deems that your business is merely an extension of you as a person (much like a sole proprietorship), rather than a separate legal entity.

Creating an operating agreement for your single-member LLC is one way to prove to a court that your company is a well thought-out business entity, and that it is indeed distinct from you as an individual. By describing your policies and practices in an organized manner, a layer of distinction is created between you and your business. Furthermore, it’s also a good idea to have some sort of plan for your LLC if you would like the company to continue operating after your death, or any other incident that would incapacitate you from running it yourself.

If you are a member/owner of a multi-member limited liability company, your operating agreement will need to designate whether your LLC is “member-managed” or “manager-managed” ― a distinction that we’ll go over in detail in just a bit. In addition, some other major differences with a multi-member LLC operating agreement compared to that of a single-member company include describing how its owners should make their financial contributions to the business, how profits will be distributed, and how to replace a member.

 

What Information Needs to Be in My LLC Operating Agreement?

Organization

You should start your operating agreement with a section that says when and where your limited liability company was originally formed. This section also includes information about the LLC’s ownership group, and 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?

Management

We mentioned earlier that a multi-member limited liability company operating agreement needs to describe its managerial structure, which can be either member-managed or manager-managed. When a company chooses to be managed by its members, the owners of the LLC take charge of the daily operations of that business.

On the other hand, if you choose to be managed by a manager, you can hire someone from outside the company to handle these aspects. This is by far the less-common option, but if your owners have other business pursuits that take up a significant amount of their time, or if you simply don’t want to be responsible for the daily minutiae, this can be a great option for you.

Voting Procedure

When a limited liability company has more than one member, there needs to be some sort of framework in place for how those owners will vote on important issues pertaining to the company. In your operating agreement, you should outline how this voting process will occur.

Obviously, the most common option is to simply allow each owner to cast one vote, but you can also choose to assign different numbers of votes based on each owner’s level of involvement with the company. In addition, you can also outline when and where the votes will take place.

Financial Contributions

Whether it’s in the startup phase, or at any other period in your limited liability company’s business life cycle, there are times when your LLC will require contributions of capital from your owners. Your operating agreement should have detailed instructions for how this money should be contributed to the business, so that there isn’t any confusion down the line. Trust us, there’s nothing worse than quarreling over money issues with your co-owners.

Income Distributions

Speaking of quarreling over money, if you think it’s awkward to argue over contributions, just imagine what it would be like to have a disagreement over distributions. 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. This is another section of the LLC operating agreement that is vitally important.

Replacing Members

Whether your limited liability company has multiple members or just one, you should have a section in your operating agreement that discusses how the ownership structure will change if a member needs to be replaced for any reason. If you fail to designate how this issue will be handled, there are some states that will actually dissolve your LLC if an owner leaves the business.

Dissolving the Company

Unfortunately, not all businesses last forever. If you need to go through the dissolution process with your limited liability company, you’ll be glad that you outlined how this step will be taken in your LLC operating agreement. 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)

You can add more sections if you’d like, or perhaps if your business operates in a specialized industry. You could include information about when and where to hold company meetings, who controls the business banking and credit cards, etc. These are not necessary for most limited liability companies, but if you would like to include this info in your operating agreement, there’s no harm in doing so.

 

How Should I Create My LLC Operating Agreement?

When it comes to actually creating your operating agreement, you have some options. You can draw one up yourself, either from scratch or using an online template (there’s quite a few available).

You can hire an attorney to draft your operating agreement for you, or perhaps enlist the help of an incorporation service like IncFile and LegalZoom that can also form your LLC for you. Obviously, hiring a lawyer is the safest route, but given the restrictions of a tight startup budget, this isn’t always feasible.

 

In Conclusion

As you can see, there’s certainly some careful thought required before drafting your limited liability company operating agreement. On the other hand, we would hope that the questions posed by this article are ones that you’ve already considered the answers for. Starting an LLC, whether it’s a single-member or multi-member operation, is a big decision that shouldn’t be ad-libbed as you go along.

We hope this article helped you develop a better understanding of the LLC operating agreement, and we hope your business future is bright for many years to come!