Drafting an LLC operating agreement may feel intimidating. But it doesn’t have to.
In the USA alone, there are about 21.6 million limited liability companies (LLCs). And the number has been growing year by year since 2004, according to the Internal Revenue Service (IRS). But, if you’re reading this wondering how to write an operating agreement, it’s likely you’ve never founded a business entity like an LLC before.
The good news is, you don’t need to reinvent the wheel. The process is straightforward and based on common practices.
However, an operating agreement is still a legal document. This means you shouldn’t copy and paste someone else’s text to use as your own without understanding what its parts entail. And understanding that can be a challenge in itself depending on your command of legal lingo.
We wrote this article to help you make sense of the different parts of a typical operating agreement. After reading it, you should feel more confident about putting one together yourself.
What is an LLC operating agreement?
An LLC operating agreement is an official internal document. It states how influence, benefits and responsibilities should be distributed among the managing business owners. An operating agreement also specifies collaboration rules for members like voting rights and how often regular meetings should take place and in which order.
Here’s how the Missouri Small Business Startup Guide defines the operating agreement.
In other words, stakeholders build their relationships according to the operating agreement. This document is more detailed than articles of association but serves a similar purpose.
Do you need it?
Most American States won’t require that you have an operating agreement. California, Missouri, Delaware and New York are the only exceptions. But even there, state default rules don’t oblige you to file your operating agreement publicly.
That’s why many entrepreneurs think it’s just another useless piece of paper. They don’t bother to write one or even make one the generic copy-and-paste way. But this is a mistake, one that could cost them a lot of trouble going forward.
Suppose your company doesn’t have an operating agreement. Someone files a lawsuit against you because they believe you caused them a financial loss.
You believe you acted on behalf of your company. Should the amount claimed be covered by the company, or from your personal funds? The court may decide for the latter and impose personal liability.
A written operating agreement, stating that the company should pay any damage done by its managing member acting on its behalf, would have prevented that.
Without an operating agreement, you will sometimes have to struggle with questions like these:
- How much more funds has a particular managing member contributed above what was required?
- How should losses be shared among the managing members?
- When should the company pay distributions to its managing members, and how much each should receive?
- Should the company cover the business trip costs of a managing member?
- Can a managing member use the company’s money, and for what purpose?
- Where should this or that document be stored?
Imagine you have to gather a meeting every time you need to make a decision on matters like those.
You’ll eventually find yourself bogged down in minutiae and failing to scale your business up rapidly. That’s why having an operating agreement for your LLC is a wise choice, even if your state laws don’t require it.
Understanding sections of an operating agreement
Legal documents like the operating agreement may look intimidating. “How could anyone write so much?” you may be asking yourself.
And if you decide to write one from a blank page, you may:
- forget to mention a few essential articles
- use non-common terms that can cause ambiguity in court
- fail to elaborate on terms and conditions to the extent necessary.
All those things can later backfire should a situation occur where the operating agreement has the last word. And that’s exactly why no one writes agreements from scratch.
For almost every type of agreement, there are key sections that don’t change much from organization to organization.
Your LLC operating agreement is no exception: just take a template, modify it and invite your fellow members to collaborate on it. But you still need to understand what each section is about.
Let’s work from an example.
PandaDoc offers all kinds of free templates, including this operating agreement template for multi-member LLCs. It’s suitable for a member-managed LLC and refers to company co-owners as “Members.”
You’ll need to start by stating the date of the business formation, the business name, its purpose, address, term, required filings policies and registered agent.
Your LLC formation date will be when it was registered with the Secretary of State to do business.
As for the purpose, most businesses describe a general idea of what the company is going to do. And you should do the same unless you’ve started the company for a very specific purpose. It typically goes like this:
The purpose of the Company is to engage in any lawful act or activity for which limited liability companies may be formed under the Act and to engage in any and all necessary or incidental activities.
Furthermore, make sure that the company address is where its office is located and does business. Don’t confuse it with the Registered Agent’s address.
The term refers to how long your company is supposed to do business. It could be a particular period of time or defined as “until the Company is dissolved as provided in this Agreement.”
The part about required filings should briefly describe what managing members shall do about documents required by the agreement or by law.
Finally, you’ll need to specify where the details about your registered agent could be found. These are typically provided in the Articles of Organization.
This definitions section is pretty straightforward. You list the terms used in the agreement and define them.
Capitalization and financing
In this section, you’ll need to state how much money each member is required to bring to the table initially. Also, make sure to specify that members are free to make further capital contributions to increase their ownership percentage.
Allocation of net income and net loss
Members of your LLC will need to understand their financial responsibility for the company’s performance. You can divide profits and losses any way it feels suitable — just make sure the rules are clear.
Most companies allocate financial responsibilities and gains based on ownership interests. For example, if a member has contributed half of the company’s capital, they’ll receive half of all profits and absorb half of any losses.
This section is supposed to describe the process of paying out distributions to the members of the LLC. However, they have the right to keep that between them, and most companies use that right.
They simply state that members determine the times and the aggregate amounts of distributions.
LLC members may go on long trips to negotiate on behalf of the company. In this case, it’s fair for the company to cover the travel costs. But the members’ right to get reimbursed must be stated clearly in this section.
Authority and responsibilities of the members
This is the largest section of the document. If you look at it in the PandaDoc LLC operating agreement template, you’ll see a long numbered list. In simple terms, it boils down to who manages the company and how (and if) these people should:
This is a general overview of the points that need to be listed in this section. But getting to know it will help you better understand the details as outlined in the template.
Assignment of the members’ interest
Every managing member has an interest rate in an LLC. If they decide to transfer or sell that interest, the company may encounter financial problems.
To avoid that, you’ll need to specify that members can transfer their interest only with the written consent of the managing majority.
Records, audits and reports
Your company will start accruing documents from day one. Of course, you can digitize most of those documents, but many will still require to be stored somewhere on paper. And all LLC members should know where to find them.
In this section, you’ll need to specify which documents (e.g. Articles of Organization, financial statements) you should store and where. Companies typically decide to keep their papers at their principal offices.
Dissolution and termination of the company
Finally, you will need to agree on what should happen if you decide to dissolve the company. Specify what bureaucratic actions managing members should take in this case and what they should do with the company’s assets.
Over to you
An operating agreement isn’t such a complicated document if you zoom out a bit and translate its points from legalese into English. Once you’ve seen it from that angle, it will be easier for you to draft your own.
And you don’t need to hire a law firm to create the first draft. However, we recommend that you consult an expert for the final review.
After all, if you already knew everything, you wouldn’t be looking around for how to write an operating agreement, right?
And remember: there will be way more documents to take care of as you proceed with your new company.
With PandaDoc, you can find lots of templates and tools to help you draft those documents and collaborate with your partners on refining them. So don’t hesitate — start your free trial now.
Frequently asked questions
LLCs are required to have an operating agreement in four states: California, Missouri, Delaware and New York.
No. Even though some states require you to have an operating agreement, you’re not obliged to file it publicly there.
An operating agreement can protect you as a managing LLC member from personal liability if the company is responsible for financial damage.
Yes. The operating agreement is a standard document. You can find many examples and templates on the internet. PandaDoc has an operating agreement template for multi-member LLCs.