The company’s operating agreement is a contract between the owners and managers. The owners can be managers or non-managing owners. Managers can be owners, but don’t need to be. Beyond the Articles of Organization, this is the most important business document and should be signed by everyone involved. No excuses.
The agreement details the rights and responsibilities of each party. This is important to ensure each party understands their relationship to the business. This helps prevent the possibility of not simply disagreements, but potentially lawsuits and other legal repercussions ahead of time.
We provide an operating agreement free of charge for all clients, along with the option to use a custom agreement with more granular control over every provision to ensure a better fit for your organization than a free template which can be found online.
Does My LLC Need an Operating Agreement?
What's the name of your company?
Is an Operating Agreement Required?
While every state differs on the legality of operating without an agreement, anytime you open a bank account, sign a contract, or go before a judge it is extremely important to have this paperwork in order. There is a section which shows not only ownership percentages, but who has the authority to sign on behalf of the company. Such questions cannot be avoided.
Thus, our answer is, yes the agreement is required and to not draft or sign is considered poor practice, at best, which opens you to legal liability in the future.
Free Templates vs. Custom Drafting
In many cases, like when there is only one Member and no plans to add additional Members, the standard operating agreement we provide with every LLC offers best-in-class asset protection. However, for multi-member LLCs when the Members are business associates with different goals and needs, a Custom Operating Agreement will reduce the likelihood of disagreements, misunderstandings, and disputes in the future.
Based on the responses you provide to the questions below, we can draft a Custom Operating Agreement that addresses the areas of LLC ownership and management that are likely to lead to member and manager disputes. We recommend you ask these questions with all members and managers present so that all stakeholders understand the available options and make decisions based on their own best interests.
What if an Agreement isn’t Signed?
If there is no written agreement for ownership, then proving who owns what is exceedingly difficult, if not impossible. Imagine being in front of a judge and trying to explain what percentage you own, but having no proof.
Even showing cash you have personally moved into the company could be viewed in a number of ways, was it an equity contribution or a loan? What if cash has moved in and out, were those salaries, distributions, or repayment of loans? Without documentation, there are multiple interpretations and a judge is unlikely to agree with any one party completely. Everyone comes away unhappy, especially knowing the situation could have been easily avoided with a few signatures at the outset.
What Percentage Qualifies as a Majority?
At minimum fifty percent of the voting interest, but a larger percentage can be required and different decisions can require different percentages. This is a choice that must be made when drafting and signing the agreement. Changes can be made, but the percentage required for those changes will have been dictated when the agreement was originally signed.
What Do Members Commonly Vote on?
Which Membership Percentage Interest is required to:
- - Change the Company Name
- - Change Registered Agents
- - File a DBA
- - Approve distributions
- - Change Tax Election
- - Distribute Non-Cash Assets, e.g. Real Estate
- - Appoint or Remove a Manager
- - Amend the Agreement
- - Etc.
In short, important operational and strategic decisions should require a quorum to ensure the company and members’ interests are best served. Some questions can be deferred to Managers if that is your wish. The exact terms can and should be clearly dictated within the agreement and signed by all parties to ensure compliance.
Single Member Agreements
Single Member LLCs, those with one owner, should still have an operating agreement, especially if there will be non-owner managers who sign contracts. Signing the agreement, even when not strictly necessary, helps show you respect corporate formalities.
In these cases, it’s also important to ensure the agreement maximizes your asset protection benefits. However, an overly complex agreement is not needed as there cannot be a partnership dispute. Further, putting certain requirements in, and failing to follow them, can make it difficult to claim you followed best practices or were unaware of certain formalities if someone attempts to pierce the corporate veil.
Multi-Member Agreements
Partnership disputes are best solved through a clear agreement in the beginning. Much like the joke 98% of employee problems are prevented during the hiring process. Beyond being careful who you do business with is the importance of a clear and concise document which states what each party's rights and responsibilities are. The lack of this makes a judge’s life difficult as they must fall back on the statute, rather than what the partners intended, and are often left guessing given finger pointing and accusations from the plaintiff and defendant.
Member Managed vs. Manager Managed Companies
In a member managed company, all members act as managers. In a manager managed, only those persons, members or not, may act as managers. So, what is the definition of a manager and what do they do?
A manager is an individual who has control over daily operations. Their authority includes tactical, and sometimes strategic, decisions, along with being allowed to sign contracts on the company’s behalf, open bank accounts, hire employees, etc.
By default, Managers may take any action that they reasonably believe furthers the Company’s interests. This may be left as a general statement, or a defined list of activities can be given. The Managers may perform the activities on the list without the need to obtain consent from the Members.
If a Manager does not perform the specified duties, as determined by the Members, the Manager may be removed. If the Manager is also a Member, they will retain their Membership Interest.
For example, you may want to state that a single Manager can only incur Company expenses up to $500 or a single Manager cannot hire a new employee without the Company’s consent. You may want the consent of all Managers in order to enter into a services contract or incur Company expenses of more than $500 but less than $1,000.
Would you like to include a provision which allows Managers to compete against the Company? Some states automatically impose a noncompete on the Managers of a Manager-Managed LLC. In certain instances, you may want to allow Managers to participate in other ventures that technically compete against the Company.
A common example is when a Member, who is also a Manager, is investing in real estate through the Company, but is also purchasing other similar real estate as an individual. Without this provision, a Manager would be violating a fiduciary duty to the LLC by purchasing similar real estate as an individual.
Distributions
Distributions from a limited liability company strictly refer to when profits are distributed from the company’s accounts to the owners. Repayment of a loan is not considered a distribution. Given an LLC’s default pass-through taxation status the profits are taxable regardless of whether they’re distributed.
Common questions to answer are:
- Will Operating Cash Flow be required to be distributed annually?
Operating Cash Flow is a measure of the amount of cash generated by a Company’s normal business operations. If you select required distributions, a creditor may be able to put a lien on these distributions. For greater creditor asset protection, we do not recommend requiring distributions. When not required, the Members must approve annual distributions.
- Which Membership Percentage Interest is required to authorize Discretionary contributions of funds to the Company?
- Majority (51%)
- Unanimous (100%)
- Other Percentage
- If the Company requires additional capital contributions by the Members, will these be mandatory or discretionary?
Discretionary contributions allow greater flexibility when the Members have unequal financial means. If one Member is unable to contribute, the non-contributing Member will be “diluted” and end up owning less of the Company. Mandatory contributions provide less flexibility, but ensure that all Members equally contribute to the Company. With mandatory contribution, If a Member is unable or unwilling to contribute for a period of one year, they will become an Assignee and lose their ability to participate in the Company, but will maintain a diluted financial interest in the Company.
Differences by State, Industry & Entity Type
Sole-Proprietorship, Corporations & S-Corporations
A Sole Proprietorship or DBA does not have an operating agreement. This is because the person operating it does not have a formal business entity and thus there is no contract. If a partner is brought in, then we recommend forming an LLC to solidify the relationship via a multi-member operating agreement.
A corporation has a shareholder agreement and bylaws. These determine ownership and control. The documents are more complex, and custom drafting is often required, but functionally they are equivalent. The owners are established via the shareholder agreement and the owners are called shareholders. The shareholders elect a board of directors and the board votes and appoints the company’s officers. This setup largely mirrors the member and manager distinction found in limited liability companies.
An S-Corp is a tax election filed with the IRS. Both Corporations and LLCs can file for this tax status. For that reason, it’s not possible to say whether an S-Corp needs an operating agreement. What determines this is the nature of the underlying entity.
Bylaws
Most states require bylaws, but not all do. We believe they’re an important part of a well functioning corporation, but some choose not to adopt them. Either because they haven’t started conducting business, they won’t want to pay for drafting or it’s forgotten. Note, every corporation we form includes free bylaws.
Bylaws define how to vote for a board of directors, whether regular board or officer meetings are required, rules for notifying owners of changes, creating committees, policies for loans to directors, etc. It’s clear bylaws can be complex, or they can be kept simple. It depends on what the owners want, but once signed they are a legally binding contract.
Organizational Minutes
Organizational meeting minutes are a formal record of the discussions, decisions, and actions that your company chooses to make. These decisions are usually made at shareholder meetings, board of directors meetings, annual meetings, and board committee meetings, but you should document any important company decisions regardless of when they are made.
Buy & Sell Agreement
Whenever an owner joins or leaves the company it’s best practice to have accompanying paperwork ratifying the change. The rules for membership differ depending on a variety of factors, e.g. Wyoming’s Close LLC won’t allow you to sell your interest to a third party without first offering the right of first refusal to existing members.
When, how, if, or under what circumstances a person can join or leave can be determined ahead of time within a company’s operating agreement. If you believe a more sophisticated clause is required to protect the company’s interests, then please contact us for a customized operating agreement.
We don’t include such provisions by default as every entity is different, and most clients, especially single-member LLCs, don’t desire the added complexity.
Can They Be Amended?
The agreement can be amended. This is easiest when all owners agree, that is when there is unanimous consent. There are, however, cases where not everyone agrees. Whether the agreement can be changed in such cases is… determined by the agreement that was already signed.
Some decisions can require a simple majority vote, meaning 51% or more of the vote. The 51% is not set in stone, but is a common dividing line. For major changes, such as those to the operating agreement, a larger percentage all the way up to 100% can be required.
It’s important to note companies that are evenly split between two owners, with each having 50%, cannot be changed without both agreeing. There are ways to mediate the dispute in court, but it’s generally best to avoid such splits.
Industry
An agreement can differ based on industry in two ways. The first is the agreement states what industries the owners can and can’t invest in. For example, if you are starting a real estate company, then it can be dictated the funds aren’t to be used toward a car leasing company. This helps ensure the company’s original intent is upheld and funds are not misappropriated.
To understand the other ways it can differ, consider a technology company. For this company intellectual property is of utmost importance and there should be special provisions relating to such.
A real estate company should consider the standard non-compete to ensure neither too broad nor narrow. Certainly, you don’t want other investors to be prohibited from all real estate transactions, e.g. if your company invests in Florida residential real estate why couldn’t a fellow member invest in California commercial real estate?
Professional companies, i.e. professional limited liability companies, have specific provisions which restrict ownership to those with proper credentials. For example, a law firm can only have attorneys as owners. Similarly for medical businesses, etc.
Simple Operating Agreements
We often see online bias against so-called simple operating agreements. This can come in the form of the question: how long is your standard agreement? We respond length isn’t the best indicator of quality. The better question is… does the agreement satisfy the owners’ intent?
We’ve seen plenty of very long, and equally unintelligible, agreements. This is most silliest when it comes to single-member member-managed companies. In these cases, there is only one person running the company. Why would they artificially restrict themselves from certain activities? Further, if the agreement dictates a large set of best practices that aren’t then followed, it will be hard to argue they didn’t know better when those practices were signed off on.
Bottom Line
An LLC Operating Agreement is a vital contract defining the rights and responsibilities of owners and managers. It is essential for clarity, preventing disputes, and minimizing legal risks. While we offer a free standard agreement with our LLC formations, custom agreements are advisable for multi-member LLCs to address specific concerns. Operating without an agreement can lead to legal complications.
Please complete our contact form. if you have any questions for us about forming your LLC. Additionally, for those seeking further clarification, attorney consultations are readily available.
Written By
Jonathan is admitted to practice law in Colorado and Wyoming. In this position, he helps business owners at nearly every level and in nearly every industry with asset protection, estate planning, and business formation. Beyond business owners, Jonathan also helps activists of all political persuasions to legally protect themselves.
