All business entities have their own set of rules and regulations meant to govern the way the business operates, who makes what decisions, and how profits or losses are distributed. For general corporations, these rules are called bylaws. In legal partnerships, the entity functions under what is called a partnership agreement. And when establishing a business as an LLC, it will follow the rules of an operating agreement*.
In an LLC, the primary function of the operating agreement is to govern the relationship between the owners of the business.
When you choose to incorporate your business in the form of an LLC, you are choosing to make it an inherently flexible entity. It will allow you to designate investors as either active or passive in the running of the business, as well as name managers or delegate specific responsibilities. Your operating agreement can spell out how profits and losses are to be shared, and in which proportions agreed upon by the members.
If you DO NOT create your own operating agreement, your business will operate under the laws governing incorporation established by your state. This can cause complications because states vary widely in their rules, and it is very unlikely that your state will have regulations that match what you and your partners (the other members of the LLC) have in mind. As an LLC owner, you will most likely want to create your own operating agreement (Link for free template).
Determining Degree of Ownership
Your LLC’s operating agreement spells out in very precise terms how much ownership each member of the business has. There is not one “right” way of dividing ownership and responsibilities, but rather a variety of ways you could choose to structure your business.
Many businesses decide to have member ownership be proportional to each member’s capital investment. For example, if Member A has invested $1000 of their personal money to start the business, and Member B has contributed $2000 of their personal funds, Member B would be designated as owning twice as many shares of the company as Member A in the operating agreement (because Member B has given twice as much money.)
However, you don’t have to allocate ownership in proportion to capital contributions. A member may choose to be a passive investor — one who does not have responsibilities for the day-to-day operation of the business — but may contribute the majority of the financial capital needed to get the business started. Another member of that same business may contribute little in financial capital, but may actively manage daily operations. In this situation, the members may consider their contributions to the overall business to be equally valuable, and therefore may choose to split the shares of the business equally.
Likewise, members may agree that while one has contributed more money to the business, the other does a larger amount of work. In this scenario, they may decide to split shares with 40% going to the former member and 60% to the later.
Such freedom to create personalized operating agreements is great benefit of forming an LLC, and is the reason LLCs are such flexible entities.
An LLC operating agreement spells out the terms of ownership, as well as how voting operates within the business. You could create an
agreement where every member gets a number of votes equal to the number of shares they own. Conversely, the agreement may grant each member an equal vote, regardless of the number of shares they hold.
The terms of your operating agreement will also precisely define how many votes constitutes a majority for making major decisions regarding
the business. You will want to spend time refining this portion of your agreement, because otherwise you will have to use your state’s default
regulations, which vary among states.
For example, in Delaware a simple majority of 51% of the vote is enough to authorize a merger of the business with another entity. In some other states, a two-thirds majority is required approve the same merger. You will want to decide for yourself, based on your personal circumstances, what number of votes you would like to constitute a majority decision for issues such as mergers or liquidations.
When you are starting your company, it is likely that most of your time will spent putting your business together, and thinking about its bright future. No one wants to contemplate the potential for unhappy customers, or disagreeable partners. One issue that does need to be addressed at the outset of forming your business is the death or retirement of one of the members of the LLC.
Your operating agreement can provide parameters for these eventualities that will be easy for members to follow and will help
guarantee the uninterrupted operation of your business. Your operating agreement can provide that remaining members are allowed the first opportunity to buy the leaving member’s shares of the business. Or your operating agreement can protect assets by removing the voting power of shares taken away from a member involuntarily.
The topic of succession planning in your LLC operating agreement is an advanced topic that you will want to spell out in depth. You may wish to speak with an attorney to further discuss the way forming an LLC allows for asset protection under these circumstance. Again, an LLC is the most flexible form of incorporation you can choose to define your business entity and specify it’s regulations.
Protecting Limited Liability of Single Member LLCs
Some people believe that if you are forming a single member LLC there is no need to create an operating agreement. After all, the operating agreement is basically designed to define terms of ownership among members for the purpose of avoiding disputes. Why would a single owner need to make an agreement with themselves? However, for the single owner, an operating agreement can help preserve your business’s limited liability status.
If you operate your single member LLC without an operating agreement, your business starts to resemble a sole proprietorship. If this happens, a judge presiding over a disagreement involving your business could decide that your LLC is not a truly separate entity from your person.
In this case, you can be held personally liable in the dispute. This is called “piercing the corporate veil” under the alter ego theory. As a single member LLC, if you take the time to create a formal operating agreement, you will be making your intention clear that you as an individual and the LLC are two separate entities.
If that happens, then a judge could pierce your corporate veil under the alter ego theory, holding that your LLC and you as an individual are actually one and the same.
Does Your Operating Agreement Have to Be In Writing?
Some people still like to conduct business on their word and a handshake. And there are several states that continue to permit members of an LLC to conduct their business with a non-written operating agreement.
States which require LLC operating agreements to be in writing:
District of Columbia
States in which no writing is required
Georgia (writing is required for single member LLCs)
Illinois (writing is required for single member LLCs)
Louisiana (writing is required for single member LLCs)
Understand from a practical standpoint that that having a verbal operating agreement and having no operating agreement can be difficult for a third party to determine…:
for example, a judge hearing a legal dispute between the LLC’s members.
Suppose member A and member B form an LLC and agree, verbally, to an operating agreement that favors member A in a certain way. Then, member A and B have a falling out and end up in litigation.
It turns out that their state’s default rules are more generous to member B on the issue in dispute. So now member A argues to the court that it should enforce the parties’ verbal operating agreement, while member B will argue that the parties never had any operating agreement whatsoever and always intended to rely on the state’s default rules. It is VERY expensive in terms of legal fees to untangle a dispute of that kind.
Other Operating Agreement Articles of Interest
Find out when your situation requires an attorney, and when you can use a low-cost template or “semi-custom” operating agreement.
Your Operating Agreement Questions…Answered
Click below to see answers to others’ questions about Operating Agreements…
Do I need to file an operating agreement within the state
Do I need to file an operating agreement with the state? If you dont have to file the operating agreement with the state, where should one keep it? In …
need to include investors in my LLC?
Hello. Great website with alot of information. Here’s my scenario: I have not yet created my LLC yet. I am attempting to buy a small multifamily property …
Can an LLC Pay Members an Hourly Wage that Varies on a Project-to-Project Basis?
Can an LLC pay its members an hourly wage, which is tied directly to the number of service hours contributed to the enterprise, and perhaps even to a percentage …
Transferring single member LLC to another person
My LLC is a single member LLC- 100% ownership is mine. I would like to transfer complete ownership to someone else(relative). Can I just make a transfer …
DIFFERENCE BETWEEN MANAGING MEMBER AND MANAGER
What is the difference between a managing member and a manager in terms of
What is the maximum number of managers/managing …
LLC Membership Agreement versus Operating Agreement
Is there a difference between an LLC Membership Agreement and an LLC Operating Agreement ? Thank you. Based on some quick research, they seem to be …
Change ownership of Illinois LLC
I and my partner formed an LLC with two owners and now we just want to have the LLC in just one owner’s name. how can i do it?
You should …
No Operating Agreement
In December of 2008, we ended the corporation that had Articles of Incorportation. On the advice of our accountant we created a new LLC, however, we did …
Operating Agreement for NJ LLC (single or multi)
Hello I have registered an LLC in the state of NJ in 2000 and being sole member I didn’t care to create an operating agreement till I have the need now …
Resigning from a LLC
Myself and another person wanted to open a restaurant. We applied for an LLC and a Hotel and restaurant license. I had some trouble with financing and …
Operating Agreement for LLC engaged in stock and forex investing Not rated yet
Want to form and LLC that will invest and trade in stocks and possibly later in the forex markets.
Will start off with myself and one investor.
Validity of Operating Agreements – Signed vs. Electronic vs. Unsigned
What is the legal standing of an unsigned Florida LLC operating agreement. I believe that no company is formed and the document can be change at will …
One LLC owning another LLC
My business partner and I are in the process of buying a business. We want to set up one LLC to actually be the purchasing party.This will …
Transfer of voting rights?
We want to protect our voting rights as members if a member dies. Its ok with us if a spouse or other person inherits the ownership but not the voting …
unsigned llc operating agreement legal?
I wish to leave an llc I have been a part of for a few months now. An operating agreement was drawn up but never signed by either party.
Is there …
Lottery winnings and the benefits of an LLC and a Trust
If I win a large lottery amount over 30 million what are the benefits to me having a family trust or foundation and a LLC. Will I be able to pay less taxes …
Our LLC of three members would like to have equal ownership and membership control, regardless of capital contributions made by individuals. …
Distributions to members
In your operating agreement do you spell out exactly how and when the members are paid out, or do you have to pay out your profits as they are incurred? …
Operating Agreement for Texas LLC
I have a Texas LLC with two members. One member wants to resign and I will remain as a single member LLC.
Because members can not resign LLC member …
Withdraw from a Florida LLC
I filed an LLC in Florida. I am the managing
member and another person is a member and
the registered agent.I no longer wish to have
this LLC since …
llc individual members rights
Can a member be silenced by other members without reason?
Member rights vary state to state, but as a general rule, members holding a minority …
Unsigned Operating Agreement
I have been with a company 14 months where another person filed the company registration papers with the state. A partnership agreement was draw up sent …
LLC for authors
I recently published a book and plan to sell it to middle and high schools. Do I need an LLC?
I think the main consideration is whether …
I heard that along with obtaining your EIN for federal you are also supposed to apply for a state filing number.
It would make since considering you …
Real Estate LLC. operating agreement?
I am forming a real estate LLC with my wife. Do we need an operating agreement? We split the ownership 50%-50%.
You really ought …
Notarizing the Operating Agreement
Does the Operating Agreement need to be notarized? If not, how do you know that the person who prepared it did not just change it and put the signature …
LLC adding partners or selling stock?
I am looking to start an LLC with one partner. We will have to hire a CEO soon, as I do marketing and he does programming.
Does an LLC allow you …
Manager Managed, Single Member LLC
Is it possible to have a single member LLC, that is managed by a another individual, that has no ownership interest in the company?
If yes, what agreements …
Is “succession planning” in an operating agreement essentially a section that deals with the transfer of membership interest in the event a member wishes …
can you have a manager and a managing member?