An LLC operating agreement defines how a limited liability company will be operated and is agreed upon by the owners of the LLC – who are known as members - during the formation process.
The operating agreement allows you to establish your own guidelines for managing your business rather than relying on the default provisions found in your state's LLC law. In most states, an operating agreement can be oral or written, but having it in writing is generally preferable as you can reference this written agreement whenever questions come up throughout the life of your LLC.
Once signed, the agreement becomes a binding contract between the members.
Why your LLC needs an operating agreement
The primary benefit of an LLC operating agreement is that it allows the members to set their own rules for how the business will be run, profits will be shared, additional contributions made, disputes resolved, new members admitted, current members allowed to leave, and almost any other provision they want. It also is a sign that the members understand that the LLC is a separate entity from themselves, which can protect the members from being held liable for the LLC's liabilities should an LLC creditor seek to “pierce the LLC’s veil”. Additionally, the agreement ensures that the owners have a shared understanding of the business’ structure and operations, which can prevent costly and divisive disagreements among the members. It also offers flexibility, as it can be tailored specifically to the LLC's and the members’ needs.
Here are some key reasons to ensure your LLC has a solid operating agreement:
- Protects the limited liability status of the LLC: One of the main reasons to create an LLC is to protect your personal assets. An operating agreement helps demonstrate that your LLC is a legal entity with its own rules and procedures, thereby strengthening this protection, should the LLC’s creditors try to collect from its members.
- Establishes clarity: Operating agreements help prevent disagreements among members by clearly defining the rules for making decisions, changing membership, and resolving conflicts. When everyone understands the rules laid out in the operating agreement, it becomes easier to make both day-to-day and long term business decisions. This can also lower the chances of disputes as the LLC continues to operate.
- Avoids default state rules: Every state has laws that establish basic rules for LLCs. These rules can affect your business unless your operating agreement states otherwise. For instance, many states require that LLC profits and losses are shared equally among owners, no matter how much each member invested. By creating an operating agreement, you can set the rules that will govern how your LLC operates, instead of relying on default rules that may not suit your business. Also, not every state has a default rule to cover every situation. If there is no default rule and no operating agreement dealing with an issue, you could end up with a costly court battle to settle the issue.
- Legally required in some states: Some states require LLCs to have an operating agreement. In most states it can be oral or written, but a few states require a written operating agreement. Even though you don’t need to file this agreement with the Secretary of State, if the state requires an operating agreement you will want to be sure to have to one to avoid any consequences of non-compliance.
Creating an LLC operating agreement
Default state LLC rules don’t always work for every business. An LLC operating agreement addresses this problem by providing your business with freedom, protection, and control. A well drafted operating agreement can be customized to meet your specific business needs and the members’ management and financial goals.
At a fundamental level, an operating agreement outlines a company's operational and financial rules and provisions. Consider it a guide for how the business is to be managed and operated.
