The LLC Operating Agreement Demystified

Creating Company Rules with an Operating Agreement

An LLC operating agreement is a key document used by one of the most common business entities—the limited liability company (LLC). Like corporations, LLCs are creatures of the laws of the state in which they are formed. The LLC structure is one of the most flexible and can accommodate business endeavors in many industries.

While LLCs are beholden to state law, the way an LLC operates will depend largely on the agreements among the owners, known as members, and who those members are. For instance, are the members active participants in the business or outside investors?

Written agreements among the members are documented in what is known as a limited liability company agreement in some states and an operating agreement in others. For ease of discussion, in this article, we will refer to it as an operating agreement.

Is an Operating Agreement Required by Law?

For those familiar with the corporate structure, an operating agreement is the functional equivalent of corporate bylaws and a shareholder agreement combined.

Bylaws are rules that govern certain corporate affairs, such as the election of directors and officers. Bylaws are legally required by statute. A shareholder agreement, on the other hand, is an optional document among the owners that addresses issues like equity transfers, distributions, and ownership.

While not required by law, creating an operating agreement is a wise idea. Let’s find out why.

Why You Need an Operating Agreement

If you intend to build your business to last, and who doesn’t, its foundation must include a solid, clear set of rules. Enter the operating agreement.

The operating agreement is critical for two major reasons. First, it establishes an agreed-upon foundation for the operation of the business. Second, it limits the application of default state rules.

A Healthy Foundation

While each member of an LLC will share the goal of success, their priorities will never be perfectly aligned. These differences can be based on many factors. Factors include, but are not limited to, risk tolerance, personal wealth, and family dynamics.

The divergence in viewpoints and ultimate goals for the business among members is usually more evident in a situation where one is an operator of the business, and the others are passive investors. In the end, though, each member will have their views on the business’s strategy and operations.

As a final product, the operating agreement serves as a collective foundation upon which to run the business, leaving less room for conflict. The process of preparing an operating agreement is just as important as the final document. This is because it allows each member to express their viewpoint, thus underscoring real and potential conflicts early in the partnership.  While discussing certain issues may be uncomfortable, failing to do so at the outset may result in significant financial and personal costs down the road.

State Intervention

As a formal legal document, an operating agreement leaves little room for ambiguity and makes provisions for eventualities that may involve the courts. In the absence of an operating agreement, however, state statutes, regulations, and case law will govern the situation. A great analogy for understanding the importance of such an agreement, in this case, is a will.  Just as all states have laws that dictate what happens to your property if you die without a will, states also have default laws and rules that apply absent an operating agreement. Ceding decisions to a third party is never a good idea, whether it be over issues involving your estate or your business.  Autonomy is critical in life and business.

Even if you — and your partners or investors, if you have any — decide that an operating agreement is not needed for your company’s internal purposes, you may nevertheless be required to prepare one. For instance, you may need one for something as simple as opening a bank account. This is because banks’ account opening checklists commonly include an operating agreement in order to confirm proper authority. Note that if the only reason you decide to adopt an operating agreement is that a bank is forcing you to, you may be able to obtain a simple ‘bank form’ from the bank.

Common Provisions in an LLC Operating Agreement

LLC operating agreements are incredibly flexible and may address almost anything the members of an LLC wish to cover. However, depending on the state of formation, there will be a few issues dictated by statute.

For example, in Illinois, there are 11 distinct items that may not be modified in an LLC operating agreement, including member rights around:

• Information.
• Expulsion.
• Distributional interests (except in limited circumstances).
• Merger approval where personal liability may arise.

When creating an operating agreement, you should always consult a legal expert. This ensures you are drafting a document that is fully compliant with the relevant statute(s). That said, operating agreements will typically include standard provisions.

Subjects Covered in Typical LLC Operating Agreements

• Equity Structure —The number of equity classes and the rights of each class. This may include voting rights, management rights, preferred economic terms, or any other distinctions among equity classes.
• Member Ownership — The percentage interest in the company or the number of units owned by each member.
• Capital Contributions — The amounts and nature of capital contributions to the business. Contributions are typically in the form of cash, but they may also include assets.
• Profit and Loss Allocations — The way in which the company’s profits and losses are divided among the members. These allocations usually follow percentage interest or could be based on the number of units owned by each member.
• Distributions — The conditions, method, and frequency for distribution. Distributions may be mandatory or at the discretion of the managers or members. Requirements for mandatory distributions may be required to cover annual tax obligations. There may also be distinctions around distributions based on the nature of the funds. For instance, operating profits vs. funds received in connection with a liquidation event like the sale of the company.
• Management — The type of management structure, the rights of management, the rights of owners, and the method of selecting management.
• Compensation — The guidelines around officer and employee compensation.
• Restrictions on Outside Activities/Competition — The activities that members or managers are prohibited from undertaking.
• Transferability of Ownership — The conditions around which equity may be transferred from one owner to another or from an owner to a third party.
• Purchase Rights and Obligations — These provisions can address many circumstances. For instance, the rights of existing members to acquire additional equity, the rights or obligations of members or the entire company to purchase the equity of a member who is dissociating from the company on a voluntary or involuntary basis.

Drafting An Effective and Flexible Operating Agreement

An operating agreement should be flexible and should be drafted in such a way that the members of an LLC can adjust its terms as circumstances change. However, modifying the terms of an LLC operating agreement will require time and legal costs. The costs could be greater if your business finds itself having to modify the agreement in response to a conflict, crisis, or other unforeseen event. So, it is ideal to create an agreement that anticipates common scenarios and addresses them in a fair, equitable manner.

The good news is that most issues that will arise in your business have already arisen in other businesses, so drafting a flexible operating agreement is not difficult if you have an experienced legal expert to guide you through the process.

An Example of a Shortsighted Operating Agreement

Two individuals agree to form an LLC. Each owner contributes $10,000 on formation for an agreed-upon 50% share of the company. The owners also agree that if one decides to leave the business for whatever reason, the remaining owner may buy the other out for the amount of their capital contributions.

Five years later, the company has a fair market value of $1,000,000 and has required no additional capital infusion by either owner. Tragically, one of the owners suffers a stroke and can no longer work. Under the operating agreement, the remaining member has the right to buy the other out for just $10,000.

In this example, the continuing member could decide that the company will pay $500,000, or at least something greater than $10,000, notwithstanding the provision in the operating agreement. However, the continuing member would not be under any legal obligation to do so. The operating agreement was clear that the amount due would be based on capital contributions only rather than something that adjusted over time based on the company’s then-current condition.

The co-owners agreement at the birth of their company appears to have been shortsighted. An experienced lawyer would have anticipated the issue. That lawyer could have helped them to create a better agreement. One that would have adjusted for company growth and outlined conditions for various buyout scenarios.

Don’t Be Penny-Wise and Pound-Foolish

Drafting an effective operating agreement is, unfortunately, not as easy as downloading a template from the internet and filling in the blanks. In fact, that approach can often be far worse than not having one at all. When forming a new LLC, don’t worry about the upfront costs of preparing an agreement. Remember, drafting good documents up front will always cost less than fighting over bad ones later.

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3. Fundamentals of Corporate Structures and Their Effects on 4 Types of Equity Offerings

[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can view at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. Comparing the LLC Manager & the Corporate Director
2. The Start-Up/Small Business Advisor Series 
3. Protecting the Principal Business Insurance 

This is an updated version of an article originally published on January 6, 2020.]

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