What Is an Operating Agreement
An operating agreement is a legally binding internal document that sets the governance rules of a limited liability company. It defines how the LLC is owned, managed, and operated.
Unlike Articles of Organization, which are filed with the state, the operating agreement is typically not filed publicly. It functions as a private contract among the members.
Most state LLC statutes either require or strongly recommend an operating agreement. Even in states where it is not mandatory, it plays a critical role in defining internal governance.
Legal Authority Behind Operating Agreements
Operating agreements are authorized under state LLC statutes. For example:
- Delaware Limited Liability Company Act Section 18 101 defines and permits LLC agreements
- Texas Business Organizations Code recognizes company agreements
- California Revised Uniform Limited Liability Company Act allows operating agreements to govern relations among members
In most states, the operating agreement can override default statutory provisions, except where the statute prohibits modification.
This means members can customize internal governance within statutory limits.
Why an Operating Agreement Matters
Without an operating agreement, state default rules apply automatically. These rules may not reflect the members’ intentions.
An operating agreement allows members to:
- Define ownership percentages
- Establish voting rights
- Allocate profits and losses
- Set management structure
- Determine procedures for admitting new members
- Outline buyout and exit terms
Clear internal rules reduce disputes and improve enforceability in court.
Banks, lenders, and investors often request a copy before engaging with the LLC.
Core Provisions in an Operating Agreement
While content varies by business type, most agreements address the following areas.
Ownership structure includes:
- Member names
- Ownership percentages
- Capital contributions
- Additional contribution rules
Management structure includes:
- Member managed or manager managed designation
- Authority of managers
- Decision making procedures
- Voting thresholds
Financial provisions include:
- Profit distribution timing
- Allocation of losses
- Tax classification elections
- Record keeping requirements
Transfer and exit provisions include:
- Restrictions on ownership transfers
- Right of first refusal
- Buy sell provisions
- Dissolution procedures
Each provision should be tailored to the specific business model.
Single Member LLC Operating Agreements
Single member LLCs also benefit from an operating agreement.
Even with one owner, the document helps:
- Demonstrate separation between personal and business assets
- Support limited liability protection
- Establish succession planning
- Clarify tax treatment
Courts reviewing liability disputes may examine whether corporate formalities were observed. An operating agreement strengthens evidence of separateness.
Multi Member LLC Governance Risks
In multi member LLCs, the absence of a written agreement creates risk.
Common dispute scenarios include:
- Disagreement over profit distributions
- Unequal capital contributions
- Deadlock in voting
- Member withdrawal
- Forced buyouts
Without written terms, courts default to statutory provisions, which may require equal profit sharing regardless of contribution.
Preventive drafting is far less costly than litigation.
State Variations You Should Know
Operating agreement requirements differ by state.
For example:
- New York requires a written operating agreement within 90 days of formation
- California allows oral or written agreements but written agreements are strongly recommended
- Delaware permits broad contractual freedom but prohibits eliminating the implied covenant of good faith
Because rules vary, the governing state statute should always be reviewed.
Practical Drafting Considerations
Before drafting or adopting an operating agreement, consider the following factors.
Business structure considerations include:
- Number of members
- Passive versus active owners
- Expected future investors
- Anticipated growth
Risk management considerations include:
- Dispute resolution method
- Arbitration clauses
- Indemnification provisions
- Insurance requirements
Long term planning considerations include:
- Succession strategy
- Disability or death of a member
- Business sale procedures
- Dissolution triggers
Generic templates may not address industry specific risks.
Common Misunderstandings
Several misconceptions frequently arise.
Operating agreements are not:
- Filed with the Secretary of State
- Required to be notarized in most states
- Identical across all jurisdictions
- Only necessary for multi member LLCs
- A substitute for professional licensing compliance
It is also incorrect to assume that forming an LLC alone is sufficient to define ownership rights.
When to Update an Operating Agreement
Operating agreements should be reviewed whenever material changes occur.
Common update triggers include:
- Admission of a new member
- Change in ownership percentage
- Major capital investment
- Change in tax election
- Merger or restructuring
Regular review ensures alignment with current operations.