What is an Operating Agreement?
Starting and owning a business comes with a number of risks and rewards.
You could do exceptionally well in a short time or come across struggles that you did not expect. During any major change, it is important for all owners and members of an organization to be on the same page about what steps to take and how decisions will be made.
An operating agreement is designed to formalize these processes so that there is no question or dispute when the time comes. While not every business structure will require an operating agreement, they are useful for almost all organizations.
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An operating agreement is a legally binding document used by businesses like limited liability companies (LLCs) to outline the company’s structure. This can include how the company will be managed, who owns the company, and what other structural factors may look like. When there are multiple members of the LLC, the operating agreement is also a binding contract between the different members.
What is the purpose of an operating agreement?
The main purpose of an operating agreement is to outline the functional and financial decision-making process for a given business. Since all members are bound by its terms, it can serve as a legal document as well as a general guideline for members of the business. Anything related to the internal operation of a business can be addressed by the operating agreement.
For business owners, this can be a way to balance protecting their own interests with those of the business. Drafting the document can involve debates and negotiations as each member ensures their specific needs are represented. While the operating agreement pertains to the business specifically, it can also serve to protect individual members.
Though operating agreements are legally binding, they can also be changed at any time throughout the life of your business. As your company changes in size, purpose, or structure, you can revisit the agreement and formally make changes agreed upon by all parties.
Which businesses need an operating agreement?
LLCs and partnerships usually have operating agreements
Operating agreements are primarily associated with limited liability companies as a business structure. In some states, your LLC cannot be formally recognized by government agencies unless an operating agreement has been created and filed.
Only 5 states require your LLC operating agreement to be filed. They are California, New York, Missouri, Maine, and Delaware. Some states allow for these to be oral agreements rather than written ones.
These requirements typically refer to LLCs that have more than one member or owner listed on their articles of organization. However, it can still be beneficial for a single-member LLC with only one owner.
The one business structure that may have a similar agreement is a partnership. In these cases, the document is usually referred to as a partnership agreement, but it will serve the same purpose as an operating agreement. As partnerships don’t offer personal liability protection or other benefits of an LLC, these agreements can be even more important.
An operating agreement is optional for sole proprietors
Other business structures do not typically need an operating agreement, as they will have an equivalent or no need for one. Sole proprietorships, for example, have only one owner and no personal asset protection, so these are typically not needed. More formal structures like a corporation require in-depth bylaws and additional governing documents that go beyond the scope of most LLC operating agreements.
What are the benefits of having an operating agreement?
Whether an operating agreement is required or not, having one in place can be very important to managing your startup and avoiding disputes. A small investment of time or money to have an agreement in place can save a lot of trouble in the future.
Prevent claims of verbal agreement
With no formal agreement in place, signed by all parties, each person can claim other agreements were made off the record. If managing members of a business entity disagree, they can begin to claim that oral or implied agreements existed. Without evidence of these agreements, it will be up to a judge to determine who is telling the truth. Having a thorough and written operating agreement eliminates misunderstandings and hearsay in the future.
Avoid default state default rules
Each state has a set of default rules related to business operations. If there is no operating agreement in place and a dispute occurs, the business will be subject to the default state rules, which may not be favorable to all parties. For example, many states have rules that require profits and losses to be divided equally among all members when there is no agreement stating otherwise.
Asset protection
While an LLC affords members personal liability protection, the operating agreement is an extra layer that formalizes this shield. The document furthers the legal boundary between the LLC and the LLC owners so that there is no question as to whether they are accountable for any debts and obligations of the company.
More credibility
An operating agreement can help a new or small business to appear more legitimate in the eyes of lenders and investors. Some banks will want to see an operating agreement before issuing a business loan so that they can understand how your money will be managed. You can be denied for not having an operating agreement in some cases. The same may be true for investors, who will want to understand how well you have defined these rules to protect their assets.
How do you get an operating agreement?
An operating agreement does not require any specific outline, though states may require particular contents to be present. The documents can be drafted personally, created from an agreement template online, or written in consultation with a business attorney or an office with legal services.
Depending on the number of members, the size of your business, and the complexity of the agreement, it may or may not be the best choice to write your agreement yourself.
The additional cost associated with a professionally drafted agreement may be worth the protection afforded in the long run.
Basic information in an operating agreement
While there is no single structure for an operating agreement, each has similar features and sections in most cases. Most operating agreements will need to include basic information about the business, such as:
- Name of the business: The formal name of the LLC, as well as the address of the registered office and business office.
- Statement of Intent: Some statement that the agreement is in accordance with all state laws and will become active when all official documents have been filed.
- Business purpose: An explanation of the business’s purpose and nature, which can include a statement of “any for any other lawful business purpose” in case of future changes.
- Term: A statement that the business will continue until terminated or dissolved per state law.
- Tax treatment: How the business will be taxed by the IRS as a sole proprietorship, partnership, or corporation.
- New members: How a potential new member could acquire an interest in the business.
Depending on the business itself, other common provisions may include:
- Identification of managers and members: Names, titles, and addresses of any initial members and managers who have been installed.
- Capital contributions: A listing of the initial capital that each member contributed and its value.
- Additional capital contributions: A rule as to whether members are required to make additional contributions or allowed to do so at will.
- Member meetings: Outline when meetings will be held, attendance requirements, and any other rules specific to those meetings.
Like any contract, the operating agreement should also lay out specific definitions of terms used in the agreement so that there is no confusion.
What to include in an operating agreement
Once the basics have been covered, operating agreements will go on to define the needs of the business, its members, and any specific situations.
Members’ ownership percentage
Owners of a company typically make contributions to get the business up and running. This can include services, cash, or property. In exchange for these contributions, they will receive a percentage of ownership proportionate to the capital they offered at the outset.
In some cases, members can choose to distribute ownership interest if agreed upon. The operating agreement should clearly define what these percentages are.
Distributive shares
Distributive shares is a common term that refers to how profits and losses will be shared. Many businesses allocate distributive shares in the same way as ownership percentages so that if someone owns 50% of the business, they would also receive 50% of the profits and losses. However, this is not a rule, and each business can choose its own model. There are rules for special allocations that must be followed if your shares and ownership are not aligned.
Profit and loss allocation
The operating agreement should also define how much of the allocated profits should be distributed to members each year. It may also dictate whether members can be paid enough to cover the cost of the income taxes they will owe on profits. Additionally, the agreement should specify where the owners are allowed to draw money from the business’ profits at their own discretion or if distributions will be made regularly.
Voting rights
When major decisions need to be made, some process for voting should be used as outlined in the operating agreement. Each member could be given one vote, or they may be given voting power that is proportional to their ownership stake.
Accounting plans
It can be helpful for an operating agreement to specify the business’s method of accounting and the fiscal year that will be used. This can also include requirements that the LLC or its members and managers disclose an audited balance sheet and audited statements of operations and cash flow to all owners. This ensures everyone has equal access to information and knows where the business’s funds are being spent.
Performance requirements
In order to ensure members are held accountable, the operating agreement can outline their rights and responsibilities. This includes the daily duties of each member, what role they are expected to perform, and hourly or salary pay. If anyone is found not to be upholding their agreement, there can also be stipulations for what would happen.
Transition plans
If one member decides to retire, passes away, or chooses to share their interest in a business and move on, the operating agreement should articulate a plan for what happens next. This includes whether the business will continue, who will receive their shares, if they may sell their shares externally or need to offer them internally first, and any other rules.
This section can also include information on what happens when a new member joins the LLC and how that may change other terms.
Dissolution terms
If the LLC closes for any reason, the exact plans should be specified in the document. This section should outline specific instructions, duties, and responsibilities of each member in this scenario. It should address what happens to any company debt, how assets will be divided, and any other rules related to member action and behavior. You may also specify that no member can operate a business under the same name in the future.
Severability
It can be important to include something called a severability clause in your agreement. This will protect certain terms of the agreement if other parts are deemed in conflict with state or federal law. The clause will state that if any part of the agreement is in conflict, the rest will stand. Without this language included, a conflict will nullify the entire document and require you to create a new one from scratch.
FAQs
How do I create an operating agreement?
An operating agreement can be a simple document created between the owners of an organization. There is no necessary format, though you can find many templates online for free or through paid offerings. If you aren’t sure where to start, business lawyers can also help you to draft the agreement and ensure it is strong.
Are operating agreements mandatory?
Most states do not require a business to have an operating agreement. Five states do have some sort of requirement, though they vary in whether the agreement needs to be written, oral, or even implied. However, it is a good idea to have an operating agreement in place even when it is not mandatory.
Do sole proprietorships need operating agreements?
By definition, a sole proprietorship has only one owner who is considered the same legal entity as the business. It is rare that an operating agreement is necessary in these cases, though it can be helpful to have some documentation on future plans for the business. No one will require an operating agreement from a sole proprietor.
Is an operating agreement the same as corporate bylaws?
Corporate bylaws are similar to an operating agreement, laying out how the business will be governed. However, bylaws are typically more complex and discuss more details of the business. They also will not name individual members of the business, as they are legally separate entities from the corporation. Bylaws are always required for a corporation.
Is a partnership agreement different than an operating agreement?
When a business is formed as a partnership rather than an LLC, a variety of different rules apply, particularly as it relates to asset protection. However, because multiple people are involved in operations, it can be helpful to have an agreement laid out early on. This is often called a partnership agreement but serves the same purpose as an operating agreement.
Do single-member LLCs need to have an operating agreement?
Single member LLCs have less need for an operating agreement than those with multiple members. However, the document can still be helpful for laying out plans regarding dissolution and liability protection. Having an operating agreement can be a good safeguard against future problems, even in these businesses.
Is an operating agreement the same as
Articles of Organization?
No, articles of organization are required when you start an LLC and will be filed with the state. This is the application that allows you to formally become a business. Operating agreements may or may not be required by the state, but they will govern the internal functions of the business and are for your use only.
Can I write my own operating agreement?
Yes, every business can create its own operating agreement however it would like. They can be as simple as a single-page document if you choose. However, be sure that anything you write will be legally sound and cover the necessary complexities of your business. You can also find many example templates online to help you with this task.
Can I change my operating agreement later?
Yes, with signatures from all members, an operating agreement can be amended at a later date. This can reflect any structural changes, new business endeavors, new members, or other changes you would like to include once your business is operational. It may be helpful to include a process for amending the agreement in the original agreement.
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