Part of the “Launch It Legally: An Attorney’s Guide to Starting Your Business” series
Do you own an LLC or are you thinking of starting one? If so, you’ll almost always need to prepare an operating agreement—and that’s in addition to the paperwork you must file with the Secretary of State to create your entity. But why do you need one? And what’s even in an operating agreement?
What Is an Operating Agreement?
An operating agreement (also sometimes referred to as an “LLC agreement”) is a legal document entered into by the members and managers of a limited liability company (read our previous blog post on “key players” for more information on members and managers). The operating agreement outlines, at a high level, how the business is run, including the rights and obligations of the members and managers, who can vote on important decisions, and what happens if a member leaves the company.
The operating agreement also specifies who the members are and how much equity each member owns. Upon forming a company, many people are surprised to learn that members and equity percentages are not filed or disclosed with the Secretary of State. This is one reason why an operating agreement is essential—it is the only document that outlines who owns the company.
Do I Need an Operating Agreement?
Legally, no (at least not in Illinois). No Illinois law requires companies to prepare or enter into an operating agreement. Other states, however, such as New York, California, Delaware, Maine, and Missouri, do require LLCs to prepare these agreements.
Even though operating agreements are not required in Illinois, business owners are strongly advised to prepare one upon forming a company, especially if there is more than one owner. This is the only document outlining how the business runs, how much money each owner invested into the company, and what happens if there is a disagreement between the owners or if an owner wants to exit the company. Disputes can quickly arise between business owners, and having a clear agreement to account for disputes is essential.
Also, if your business anticipates needing a loan or adding more members in the future, you likely will have to disclose your operating agreement. Finally, since it clearly delineates the LLC as a separate entity, an operating agreement strengthens liability protection for its members.
What Are the Most Important Terms of an Operating Agreement?
Since operating agreements are not legally required, there is no set structure or form for one. However, a well-drafted agreement will include the following terms:
- Rights and duties of members: What decisions are reserved for the members, and which members are allowed to vote on these decisions? Often, only significant decisions are reserved for the members (e.g., the sale of the business, amending the operating agreement, adding a member), but these issues need to be spelled out in the agreement. The agreement should also specify if the members are subject to a non-compete restriction and it should outline the company’s conflict of interest policy.
- Rights and duties of managers: In a manager-managed LLC, the manager(s) runs the business. The operating agreement should specify who the manager is and what decisions the manager(s) is/are responsible for (e.g., employment of individuals, entering into contracts on behalf of the company, purchasing assets of the company). The agreement should also delineate how a manager can be removed.
- Contributions of members: The operating agreement should outline how much each member has contributed to/invested in the company, whether the company can request that members contribute more to the company, and the treatment of capital accounts of members.
- Allocations and distributions to members: This specifies how members are paid from net profits, as well as the company’s discretion to withhold payments if it determines the company cannot pay them.
- Tax matters: Will the LLC be taxed as a pass-through entity or an S-Corp? Who is the “tax matters representative” (i.e., which member/manager is responsible for tax matters)?
- Buy/sell terms: Perhaps the most important part of the operating agreement, the buy/sell terms (also referred to as “member disassociation” or “transfer of interests”) outlines how a member can exit the company (whether by force-out, death/disability, or voluntary exit). These sections are usually quite detailed, and outline notice procedures for an exiting member, whether the company or remaining members have a right of first refusal to purchase the exiting member’s interest, and the purchase price and payment terms for the exiting member’s interest. Much business litigation results from owners either not having strong buy/sell terms in operating agreements, or not adhering to the existing terms, so it is important to protect the company by ensuring there are processes in place in the event a member exits.
- List of members and ownership percentages: This may change as new members are added or members leave.
Keep in mind operating agreements are only for LLCs (corporations require different internal documents, such as bylaws and a shareholder’s agreement). Even if not legally required, an operating agreement can provide a touchstone for consistency and proper procedures in how your business is run. It will also help an organization avoid liability and navigate the myriad ad hoc challenges that confront any business.