What is an Operating Agreement? Key Things You Need To Know

Starting and running an LLC comes with many responsibilities, and having a clear plan for how your business will operate is key to long-term success. An operating agreement is one of the most important documents an LLC can have, setting the rules for ownership, management, and financial decisions.

This guide will walk you through everything you need to know about operating agreements, from what they are and why they matter to the key components they should include.

What Is an Operating Agreement?

An operating agreement is a foundational document for a limited liability company (LLC) that outlines the rules and structure for how the business operates. It acts as the company’s internal rulebook, defining ownership, management roles, financial responsibilities, and decision-making processes.

• For single-member LLCs, the document serves as proof that the business is separate from the owner’s personal affairs, reinforcing the limited liability status.
• For multi-member LLCs, it provides clarity by defining ownership percentages, voting power, and operational roles, which helps prevent misunderstandings and disputes among members.

The rising popularity of LLCs makes operating agreements more important than ever.

In 2023, Wyoming alone had 166,960 entities incorporated, with 92% of them being LLCs. This significant growth highlights why having a well-crafted operating agreement is essential to ensuring these businesses can operate smoothly, avoid disputes, and remain legally compliant.

Key elements typically included in an operating agreement are:

• Ownership structure and members’ responsibilities.
• Rules for voting and decision-making.
• Guidelines for financial contributions, profit distribution, and loss allocation.
• Procedures for transferring ownership and dissolving the company.

While an operating agreement is not always legally required, it is highly recommended for every LLC. It not only formalizes the structure of the business but also ensures compliance with state laws and protects the company’s status as a separate legal entity. It also complements the LLC certificate requirements that formalize your company’s legal standing.

For a detailed example of an operating agreement, you can refer to this real-world example filed with the SEC. 

Keep in mind that every operating agreement should be customized to suit your LLC’s specific structure and needs, so consult a legal professional before adopting any clauses.

Why Every LLC Needs an Operating Agreement

An operating agreement is more than just a document outlining the structure of an LLC—it is essential for protecting its members and ensuring long-term success.

By creating a tailored agreement, members can avoid the pitfalls of relying on state default laws, which may impose rigid or unsuitable rules on the business.

The primary reasons to have an operating agreement include:

• Legal Protection: The agreement provides a formal distinction between the business and its members, reinforcing the limited liability status by clearly defining roles, responsibilities, and governance procedures. This helps to ensure that members are not held personally liable for the business’s debts and obligations, thereby enhancing legal protection and clarity. 
• Customized Control: Unlike corporations, which follow rigid rules, LLCs can use the operating agreement to define voting rights, profit-sharing arrangements, and decision-making processes. Without this document, the LLC defaults to state-mandated rules, which may not align with the members’ intentions or goals.
• Preventing Disputes: Addressing important topics such as profit distribution, member exits, and decision-making procedures upfront minimizes misunderstandings and ensures smoother operations. For instance, it can specify how profits will be shared among members or how major business decisions, such as taking on new partners, will be approved. Having invested in numerous early-stage startups, I’ve seen firsthand how a well-crafted operating agreement can prevent misunderstandings and disputes among members.
• Enhancing Credibility: Financial institutions and investors often require a comprehensive set of documents, including an operating agreement, to assess a company’s legitimacy and professionalism. The operating agreement is particularly important as it outlines the company’s structure, ownership, and operational guidelines, providing clarity and reducing risk.

Even in states where operating agreements are not legally required, they provide critical benefits, ensuring clarity, protecting members’ assets, and reinforcing the LLC’s legitimacy.

For a single-member or one-person LLC, establishing an operating agreement is also important to separate personal and business activities.

As MyCompanyWorks emphasizes, “Even if your state doesn’t require one, it’s ideal for even single-member LLCs to establish an operating agreement that includes business operating procedures to fully establish your business.”

Decision-Making and Voting Rights

As someone who has led value creation initiatives within a major technology company, I understand that clear decision-making and voting processes are essential for an LLC’s smooth operation.

An operating agreement establishes these processes to ensure all members understand their roles in governing the business.

Voting Rights are often tied to ownership percentages, but they can also be structured differently based on the members’ agreement.

For instance, a member with a 70% ownership stake might naturally hold 70% of the voting power, but the operating agreement could specify equal voting rights for all members regardless of their stake, depending on the nature of the business.

The agreement also defines decision-making thresholds, which establish the level of approval required for different types of decisions. Routine decisions, such as approving minor expenses, might only require a simple majority vote.

However, significant matters, like amending the operating agreement, admitting new members, or dissolving the business, may require unanimous approval to ensure that all members are aligned.

In addition to these elements, the agreement can specify how and when meetings are conducted.

It might require annual or quarterly meetings to discuss strategy or address operational concerns, ensuring that members are regularly involved in major decisions. For example, a virtual meeting provision could allow remote members to participate without being physically present.

Financial Contributions and Allocations

One of the most critical aspects of an LLC’s operation is how its finances are managed.

An operating agreement formalizes financial contributions, profit and loss sharing, and distributions among members, ensuring transparency and preventing disputes.

• Capital Contributions define the initial and ongoing investments each member makes into the business. These contributions can be in the form of cash, property, or even services. For example, one member might contribute $50,000 in cash, while another offers specialized expertise or equipment valued at $30,000. The agreement specifies these contributions and clarifies whether additional investments will be required in the future.
• Profit and Loss Allocations outline how financial outcomes are shared among members. In most cases, profits and losses are distributed in proportion to ownership percentages. However, an operating agreement can establish alternative arrangements. For instance, two members might decide that profits are split 60/40, even though one owns 50% of the company, to account for their varying levels of involvement or expertise.
• Distributions detail when and how members will receive payouts from the LLC’s earnings. The agreement can specify whether distributions occur quarterly, annually, or only when certain financial conditions are met, such as maintaining a minimum cash reserve. These guidelines ensure that the business remains financially stable while rewarding its members fairly.

By clearly defining these financial policies, the operating agreement provides a strong foundation for managing the LLC’s resources and avoids misunderstandings that could disrupt its operations.

Transfer of Membership Interest

Transferring ownership in an LLC is a significant event that can impact the company’s operations and membership dynamics.

An operating agreement ensures that these transitions are managed smoothly and fairly by establishing clear guidelines for transferring membership interests.

The agreement typically distinguishes between complete transfers and partial transfers.

A complete transfer occurs when a member sells their entire ownership stake, while a partial transfer involves selling only a portion.

For example, a member might sell 50% of their ownership while retaining the other 50%.

To maintain stability and control, many operating agreements include restrictions on transfers, such as:

• Requiring the approval of existing members before a transfer can take place.
• Including a “right of first refusal,” which allows current members to purchase the departing member’s interest before it’s offered to an outside party.
• Limiting transfers to approved individuals or entities, such as family members or investors aligned with the LLC’s goals.

The agreement also addresses legal and financial considerations, such as tax implications and changes in voting power or profit-sharing arrangements.

For example, if a member with a 40% ownership stake transfers their interest, the voting structure and profit allocation may need to be adjusted to reflect the new ownership.

By establishing a clear process for ownership transfers, the operating agreement protects the interests of existing members, ensures stability within the business, and prevents potential conflicts.

Dissolution and Winding Up

An operating agreement is crucial for outlining the process of dissolving the LLC, should the need arise. 

Dissolution marks the formal end of the company, and the operating agreement ensures this process is handled systematically and in compliance with state laws. Without clear guidelines, dissolving an LLC can lead to confusion, legal challenges, or disputes among members.

The agreement typically specifies conditions for dissolution, such as:

• A unanimous vote by members to dissolve the LLC.
• The expiration of the LLC’s stated term (if it was established for a specific duration).
• Events like bankruptcy or a court order.

Once the decision to dissolve has been made, the winding-up process begins. This involves finalizing the company’s obligations and distributing its remaining assets.

Steps may include:

1. Settling any outstanding debts or legal claims.
2. Notifying creditors, employees, and other stakeholders about the dissolution.
3. Liquidating assets, if necessary, to satisfy financial obligations.
4. Distributing remaining funds or property among members, often based on their ownership percentages.

State laws often require the filing of a formal notice of dissolution with the Secretary of State or another relevant authority. The operating agreement should reference this requirement and ensure members are aware of their legal responsibilities during this stage.

Detailed provisions for dissolution and winding up ensure that members are protected and that the process is carried out efficiently and fairly, even at the end of the LLC’s lifecycle.

Amendment Procedures

As an LLC evolves, its operating agreement may need to be updated to reflect changes in ownership, management, or financial arrangements. Clear amendment procedures outlined in the agreement ensure these updates are handled systematically and fairly, preventing potential disputes among members.

The operating agreement typically includes:

• Proposal Requirements: Specifies how members can propose changes, such as submitting written requests detailing the proposed amendment.
• Approval Thresholds: Defines the level of consent needed for amendments. Routine updates may require a majority vote, while significant changes—such as altering ownership shares or dissolving the LLC—might demand unanimous approval.
• Formal Documentation: Ensures that approved amendments are incorporated into the agreement with a clear record of the changes, including the effective date and member approvals.

For example, if a member wants to introduce new rules for profit distribution, they might submit a proposal for review. The remaining members would then vote based on the approval thresholds specified in the agreement.

With my background in financial policy advisory during the Great Financial Crisis, I recognize the significance of having a structured amendment procedure to ensure that the LLC can adapt to changing circumstances while maintaining transparency and trust among members.

Buy-Sell Provisions

Buy-sell provisions are an essential part of an operating agreement, outlining the process for handling changes in ownership when a member exits the LLC. 

These provisions protect the business and its remaining members from disruption while ensuring a fair transfer of ownership.

Key elements of buy-sell provisions often include:

• Trigger Events: These are specific situations that activate the buy-sell agreement, such as a member’s death, retirement, bankruptcy, divorce, or voluntary exit.
• Valuation Method: The agreement specifies how the departing member’s ownership interest will be valued. This could involve an agreed-upon formula, a third-party appraisal, or a predetermined buyout price.
• Buyout Terms: Defines how the buyout will be structured, including payment terms (e.g., lump sum or installments) and the timeline for completing the transfer.
• Right of First Refusal: Gives existing members the option to purchase the departing member’s interest before it’s sold to an external party, ensuring that ownership remains within the LLC.

For example, if a member decides to leave the business, the buy-sell provision might require their ownership stake to be offered to the remaining members first, at a value determined by a pre-agreed formula. This ensures a smooth transition without disrupting the company’s operations.

Clear and detailed buy-sell provisions minimize disputes, protect the LLC’s stability, and provide all members with confidence that ownership transitions will be handled fairly.

Dispute Resolution

Disputes are inevitable in any business, and LLCs are no exception.

A well-crafted operating agreement includes dispute resolution provisions to address conflicts efficiently and minimize disruption to the business. By providing a structured framework, these provisions help members avoid costly and time-consuming litigation.

Common methods of dispute resolution include:

• Negotiation: Members agree to attempt to resolve disputes informally through direct discussions before escalating the issue.
• Mediation: A neutral third party facilitates discussions between members to help them reach a mutually agreeable solution.
• Arbitration: Members submit the dispute to an arbitrator, whose decision is binding and enforceable, offering a quicker and less expensive alternative to court proceedings.
• Litigation: While typically a last resort, the agreement may specify circumstances where disputes can be taken to court, such as breaches of the operating agreement.

The agreement might also outline the timeline for resolution and specify the jurisdiction or venue for arbitration or litigation.

For instance, all disputes may be required to be resolved in the state where the LLC was formed.

Having coached thousands of candidates for elite finance jobs, I know that including dispute resolution provisions in the operating agreement ensures conflicts are handled in a fair, structured, and cost-effective manner, allowing the business to focus on its operations rather than prolonged disputes.

Operating Agreement Best Practices

Creating a comprehensive and effective operating agreement requires careful planning and attention to detail. By following best practices, LLC members can ensure the agreement serves as a reliable guide for the company’s operations and governance.

Here are some best practices to consider when drafting an operating agreement:

• Tailor the Agreement to Your Business: Avoid using generic templates. Customize the document to reflect the unique needs, goals, and structure of your LLC.
• Include All Members in the Drafting Process: Involving all members ensures transparency and promotes agreement on critical terms, reducing the likelihood of future disputes.
• Be Specific but Flexible: While the agreement should cover all key aspects, it should also allow for amendments as the business grows or circumstances change.
• Address Potential Conflicts: Include clear provisions for dispute resolution, decision-making thresholds, and member exits to minimize ambiguity during challenging situations.
• Seek Professional Guidance: Work with an attorney or legal expert familiar with LLC laws in your state to ensure the agreement complies with applicable regulations and protects all members’ interests.

An effective operating agreement balances clarity and flexibility, ensuring that it meets both current and future needs. Regularly reviewing and updating the document can keep it aligned with the company’s evolving goals and structure.

State Requirements and Compliance

The requirements for operating agreements vary by state, and understanding these differences is crucial for ensuring your LLC remains compliant.

While not all states mandate an operating agreement, having one is strongly recommended in every state to formalize the company’s structure and protect its members.

Some states, such as California, require LLCs to have an operating agreement, while other states like New York and Delaware do not have a legal requirement but strongly recommend having one to avoid potential conflicts and ensure clear management and ownership structures.

Key compliance factors to consider include:

• Filing Requirements: Most states do not require the operating agreement to be filed with state authorities, but it must be readily accessible for legal or financial purposes.
• Single-Member LLCs: Even if you are the sole owner of the LLC, some states may still require an operating agreement to establish the LLC as a separate legal entity.
• Updates and Amendments: State laws may change over time, so it’s important to periodically review your operating agreement to ensure compliance with new regulations.

For example, in New York, LLCs must adopt a written operating agreement within 90 days of formation, even if it’s a single-member LLC. In Delaware, an operating agreement is required but does not need to be filed with the state.

Ensuring your operating agreement meets your state’s requirements not only protects your LLC’s legal standing but also demonstrates the professionalism and organization of your business.

Frequently Asked Questions

Can a single-member LLC enforce an operating agreement?

Yes, courts and financial institutions recognize operating agreements for single-member LLCs. They are essential for proving the separation between the business and personal assets, especially in legal or financial disputes.

Who keeps a copy of the operating agreement?

All members of the LLC should have a signed copy for their records. Additionally, the document should be stored in a secure location, such as with legal or financial advisors, and be readily accessible for business operations or legal requirements.

Can a new member join the LLC without an operating agreement?

Technically, yes, but this could lead to confusion or disputes. An operating agreement outlines the process for admitting new members and the terms of their ownership, making it a vital document for such changes.

Are there tax implications tied to operating agreements?

Operating agreements can influence the tax classification of an LLC by specifying whether it will be treated as a partnership, disregarded entity (which may be similar to a sole proprietorship for single-member LLCs), or corporation (either C corp or S corpo).

However, the actual tax treatment depends on the default classification rules and any elective changes made through IRS forms, such as Form 8832 for C corp and Form 2553 for S corp. Consult with a tax professional to ensure compliance with federal tax laws and to navigate the complexities involved.

Learn more about LLC vs C Corporation.

Do operating agreements expire?

Operating agreements do not have a fixed expiration date. However, they may need to be updated or amended over time to reflect changes in ownership, business goals, or applicable laws.

What happens if the operating agreement conflicts with state laws?

While state laws can override specific terms in an operating agreement if those terms violate legal requirements, the relationship is complex and varies by jurisdiction.

For example, UCC § 9-406 and § 9-408 override certain anti-assignment provisions, and some states like New York require a written operating agreement.

Conclusion

An operating agreement is the backbone of a well-structured and legally protected LLC. By defining the rules for ownership, management, decision-making, and financial arrangements, it provides clarity and minimizes the risk of disputes.

Even in states where operating agreements are not legally required, having one ensures the business operates smoothly and remains compliant with state laws.

Whether your LLC has one member or many, a thoughtfully crafted operating agreement protects your personal assets, reinforces the business’s legitimacy, and supports its long-term success.

An operating agreement is specific to LLCs. If you’re still deciding on the right structure for your business, explore more about the different types of business entity structures.