Operating Agreements: What Every LLC Owner Must Know

When a limited liability company is formed, the secretary of state receives the articles of organization and issues a certificate of formation. What the state does not provide is the document that actually matters most: the operating agreement. An operating agreement is the contract among the LLC’s members (and managers, if applicable) that governs how the company makes decisions, allocates profits and losses, handles new and departing members, and resolves disputes. Without one, the default rules of the state’s LLC statute apply — and those rules are designed for generic situations, not your specific business.

Is an Operating Agreement Required

Most states do not require LLCs to have a written operating agreement to exist or operate legally. California, Delaware, Maine, Missouri, and New York are among the states that do require one in some form. But the absence of a legal mandate is a poor reason to skip the document. Without a written operating agreement, courts and disputes default to whatever the applicable state LLC statute says — and state statutes often produce results that the members never intended, particularly around voting rights, profit distributions, and what happens when a member wants out.

Key Provisions Every Operating Agreement Should Address

Ownership Structure and Capital Contributions

The operating agreement should specify each member’s ownership percentage (or units of membership interest) and the capital contributions — cash, property, or services — that each member has made or is committed to making. It should also address what happens if additional capital contributions are needed: are members obligated to contribute more, and if so, on what terms? Can members who do not contribute face dilution? These questions frequently become contentious in multi-member LLCs, and answering them in advance is far preferable to litigating them during a financial crisis.

Profit and Loss Allocations

One of the most powerful features of the LLC structure is the ability to allocate profits and losses in ways that do not correspond to ownership percentages — something that S-corporations cannot do. The operating agreement should specify how profits and losses are allocated among members and when and how distributions are made. It should also address the difference between tax allocations (what appears on each member’s K-1 for income tax purposes) and cash distributions (actual money distributed from the company), and specify whether the company will make distributions sufficient to cover members’ tax liabilities on pass-through income.

Management Structure

LLCs can be structured as either member-managed (all members participate in management) or manager-managed (a designated manager or group of managers runs day-to-day operations, while other members are passive investors). The operating agreement should specify which structure applies and define the authority of managers and members clearly. It should identify which decisions require a simple majority vote, which require a supermajority, and which require unanimous consent. Major decisions — admitting new members, taking on significant debt, selling the business, amending the operating agreement — typically warrant heightened voting requirements.

Transfer Restrictions and Rights of First Refusal

Most operating agreements restrict a member’s ability to transfer their membership interest to a third party without the consent of the other members or the company. This prevents a member from selling their interest to an unknown third party and bringing an unwanted co-owner into the business. Common transfer restriction mechanisms include rights of first refusal (giving the company or other members the right to purchase the departing member’s interest at the proposed sale price before the member can sell to a third party), tag-along rights (giving minority members the right to participate in any sale by a majority member on the same terms), and drag-along rights (giving majority members the right to require minority members to join in a sale of the company on the same terms).

Buyout Provisions

What happens when a member wants to leave, becomes disabled, dies, divorces, or goes bankrupt? The operating agreement should address each of these triggering events with clear buyout provisions. It should specify how the buyout price is determined (appraised fair market value, a formula, or a price agreed upon at the time of the triggering event), whether the payment is made in a lump sum or over time, and whether the company or the other members have an option or obligation to buy out the departing member’s interest. Without these provisions, the default rules may allow a departing member’s creditor or ex-spouse to obtain the membership interest, creating serious governance problems.

Deadlock Resolution

In a 50/50 LLC, any management decision can result in a deadlock if the two members disagree. The operating agreement should include a deadlock resolution mechanism — whether that is a buy-sell provision (a shotgun clause where one member names a price and the other chooses whether to buy or sell at that price), a mediation or arbitration requirement, or a designated tiebreaker. LLCs without deadlock provisions can find themselves in expensive dissolution proceedings over disputes that could have been resolved through a well-drafted agreement.

Dissolution and Wind-Up

The operating agreement should specify the circumstances under which the LLC will dissolve — which may include member vote, achievement of the business purpose, expiration of a fixed term, or the occurrence of a specific event — and how the wind-up process will be managed. It should also specify the priority of payments during wind-up: creditors are paid first, then members in accordance with their capital account balances and distribution rights.

Single-Member LLCs and Operating Agreements

Single-member LLCs often skip the operating agreement on the theory that there is no one to contract with. This is a mistake. An operating agreement for a single-member LLC serves several important purposes: it documents the formalities of the business (supporting the liability shield), it provides instructions for what happens to the business if the owner becomes incapacitated or dies, and it is frequently required by banks when the LLC opens a business bank account or applies for a loan.

The Bottom Line

The operating agreement is the most important document a multi-member LLC will ever sign, and it is one of the most important a single-member LLC should have. Template operating agreements downloaded from the internet are better than nothing, but they frequently fail to address the specific circumstances of the business and its members. An operating agreement drafted by a business attorney familiar with your state’s LLC law and the specific needs of your business is one of the most valuable investments you can make when forming an LLC.