What Is an Operating Agreement? Do I Need One for My LLC?

Many entrepreneurs often find themselves having to deal with uncertainty when deciding what type of company structure to use and how to manage their business. Questions such as what are the costs of incorporating or the value of a shareholder agreement arise spontaneously and are inevitably intertwined with business planning.

For LLCs, there is a fundamental (though not mandatory) document that provides great help in defining company rules and operating principles: the operating agreement.

But what is an operating agreement in practice? It is an internal company contract that defines functions, structure, ownership, responsibilities, and every aspect vital to understanding how the organization works. As mentioned, it is not mandatory, but it is strongly recommended to protect shareholders’ rights and establish operating rules.

Similar instruments exist in many jurisdictions internationally. In Germany, there is the “Gesellschaftsvertrag” for GmbHs, in France, the “Pacte d’associés” for SARLs, and in the UK, the Articles of Association for Ltd. companies.

Understanding an Operating Agreement

An operating agreement can be defined as the internal statute of the LLC. It clarifies how the company is managed, how responsibilities are distributed and how profits are managed. Although some states require it by law, it is optional in most cases. Optional, however, does not mean superfluous. Banks, courts and regulators often require its presence as a sign of credibility, organization, and compliance with soundest practices.

Without it, members resort to predefined statutory rules. These rules are generic and may not reflect members’ real intentions, exposing the company to future disagreements.

What Is an Operating Agreement for an LLC?

So, what is an operating agreement for an LLC? For LLCs, the operating agreement is the cornerstone of the company’s rules, functions, and business structure. Unlike corporations, for example, there are no articles of incorporation or bylaws, so the LLC is governed by this document.

This tool protects the rights of members by defining, for example, the percentage of ownership of each member. But that’s not all: it regulates the distribution of profits and losses, establishes clear procedures for capital contributions, the departure or arrival of new members, and sets out the rules in the event of the company’s dissolution or disposal.

In LLCs with a single member, an operating agreement may seem superfluous, but in LLCs with multiple members, it is essential for establishing rules, preventing conflicts, and regulating their internal structure.

What Is an LLC Operating Agreement?

From a legal standpoint, an LLC operating agreement is a binding contract between members that governs the internal affairs of the company. It differs from the articles of organization, which serve only to register the LLC with the state, and the articles of incorporation, which serve a similar function in corporations.

So, what is an LLC operating agreement​? In practice, the operating agreement serves as a reference point for day-to-day decisions, capital contributions, and even exit strategies.

Key Components of an Operating Agreement

Ownership Structure

The first pillar of the agreement is the ownership structure. It records who owns what percentage of the LLC and under what conditions new members can join. Ownership is usually linked to the amount of capital invested, but members may decide to recognize contributions in terms of time, intellectual property, or other resources. However, these contributions must be “quantified” by establishing their nature and value.

An internal register or clauses specifying who owns what are required to record the shares.

Management and Voting Rights

The second aspect is management and voting rights within the company. In member-managed structures, all members have the right to make decisions and therefore participate in day-to-day management. 

In manager-managed structures, on the other hand, members appoint one or more managers and delegate company management to these individuals. Voting rights, on the other hand, may be based on a percentage of ownership shares or be equal for all without considering contributions. 

Finally, the operating agreement also establishes which decisions require a simple majority and when an absolute or unanimous majority is required. 

Profit and Loss Distribution

Moving on, the operating agreement defines how profits and losses are to be distributed among the partners. Generally, this is proportional to ownership shares, but members also have the option to decide otherwise. 

The document also defines the frequency of profit distribution, establishing whether this takes place monthly, quarterly, or annually. Furthermore, it may be decided not to distribute profits, but rather to reinvest them in the company to generate growth, creating a structured reinvestment program agreed upon by the members.

Duties and Responsibilities of Members

With regard to members’ duties and responsibilities, the operating agreement establishes who signs contracts, who handles marketing, and who manages financial resources, including external contracting when needed.

Moving on to liability, one of the main reasons for creating an LLC is to limit personal liability. In fact, members are not liable for company debts with their personal assets, unless prior agreements stipulate the contrary, or when there is a failure of legal compliance.

Dissolution and Exit Clauses

The final step is to establish the rules for dissolving the company and, therefore, the exit clauses. As a rule, the procedure involves a vote by the members, the repayment of debts, the liquidation of assets, and finally the distribution of proceeds. Not only that: the operating agreement also sets out the clauses for the exit of a partner, establishing how the value of their share is calculated. The same applies in the event of the death of a partner. The succession agreement establishes whether the share passes to its heirs, to the other partners, or must be liquidated.

Why an Operating Agreement Is Important

The importance of an agreement between members cannot be underestimated. Indeed, the operating agreement acts as a written reference point in the event of disagreements between shareholders to prevent any disputes, ensuring clarity and reassuring stakeholders.

Single-member LLCs also benefit: regulators and banks view them more seriously when agreements of this type are in place, since they demonstrate regulatory awareness and structured governance.

In short, the operating agreement makes the difference between operating an LLC on the basis of assumptions and operating it under agreed rules.

Is an Operating Agreement Legally Required?

Not all jurisdictions require an operating agreement. States such as California and New York require it, while others consider it optional. However, in practice, “optional” should be interpreted as “strongly recommended”. Without an agreement, members are subject to generic laws that may not be in line with their expectations.

Global Perspective on Operating Agreements

Many countries do not use the term operating agreement, but still have similar governance instruments. To give a few examples:

• Shareholders’ agreements in joint-stock companies or even limited liability companies;
• Partnership agreements in partnerships;
• Articles of association or articles of incorporation in many European jurisdictions.

In reality, these documents all serve the same purpose: to establish internal rules, define shareholders’ rights and duties, and decide on the criteria for distributing profits and losses, ensuring clarity for businesses operating in different jurisdictions. Obviously, each jurisdiction has different rules, so agreements must be governed in accordance with local regulations and compliance standards. In transnational contexts, it is highly recommended to rely on business formation consulting solutions to ensure that agreements are enforceable, especially when contracting with partners across multiple jurisdictions..

FAQs

What is an operating agreement?

An operating agreement is the set of governance rules and structure of a company, established in a written document.

What is an operating agreement for an LLC?

For LLCs, this is a written agreement between members that defines the structure, rules on capital contributions and ownership, as well as the criteria for dissolution or transfer of shares. 

What is an LLC operating agreement?

It is the legal name for the contract that formally governs an LLC.

Do all states require an operating agreement?

Not necessarily. The rules vary from state to state, but as a general convention, even if not required by law, it is highly recommended for all LLCs.

Why does a single-member LLC need an operating agreement?

Because this demonstrates that the LLC is separate from the sole shareholder. An operating agreement lends greater credibility to your business with banks and investors, and provides useful assistance in clarifying roles and governance.

Can an operating agreement be changed?

Yes, it is possible through amendments. To do so, a majority or unanimous consent is required, depending on the rules previously established.

What happens if I don’t have an operating agreement?

In this case, the LLC will follow the standard rules set forth by the state of incorporation, significantly increasing the risk of conflicts.

References

Thomson Reuters. (2023). What Is an Operating Agreement

https://legal.thomsonreuters.com/en/insights/articles/what-is-an-operating-agreement

U.S. Small Business Administration. (2023). Basic Information About Operating Agreements.

https://www.sba.gov/blog/basic-information-about-operating-agreements

Wolters Kluwer. (2023). What Is an LLC Operating Agreement and Why Do You Need One?

https://www.wolterskluwer.com/en/expert-insights/what-is-an-llc-operating-agreement-and-why-do-you-need-one