LLC Operating Agreement -- Do you need one?

LLC Operating Agreements

Corporations have bylaws. Partnerships have partnership agreements. With an LLC, the operating agreement controls how the company is run. Most importantly, it governs the relationship between the owners.

LLC's are inherently very flexible entities. You can have passive investors and active managers. You can share profits and losses in proportion to ownership of stock, or in any other proportion agreed upon by the members.

Without an operating agreement, the laws of your state of incorporation will control your LLC. This is dangerous because every state is different and it's unlikely that your state's rules are what you and your partners (members) have in mind.

Instead, you want to create your own operating agreement.

NOTE
You get a semi-customized operating agreement, free, when you use LegalZoom to form your LLC.

Determining Ownership--the LLC Operating Agreement

Your LLC's operating agreement spells out how much ownership each member has. Many companies choose to have ownership be proportional to capital invested. In other words if Member A invests $1,000 and Member B invests $2,000, then B will have twice as many shares as A.

However, you don't have to allocate ownership in proportion to capital contributions. A passive investor might contribute the majority of the capital, while a member that actively manages the company will own shares in excess of his capital contributions. For example, Smith, a passive investor, might invest $10,000 in the LLC in exchange for 40% of the shares, while Jones--the manager and visionary of the company--might contribute $5,000 in exchange for the other 60% of the company. Any combination can be chosen by the members.

Operational Control

Not only does the operating agreement control the ownership of shares in the LLC, it also spells out how voting operates. You could choose to have one share equal one vote. Or, the operating agreement could give each member an equal say regardless of the number of shares held.

The agreement will also spell out what constitutes a majority for making major decisions affecting your company. You will want to spell this out because each state's default rules are different.

For example, in Delaware, a simple majority of 51% is enough to allow a merger of the company. In some other states, it takes a two-thirds vote to approve a merger. You will want to decide yourself, based on your own circumstances, what number of votes are needed for major decisions like mergers and liquidating your LLC.

Succession Planning

No one wants to think about this when starting their company, but what happens if a member dies or retires? The operating agreement can provide, for example, that the remaining members are allowed the first opportunity to buy the leaving member's shares.

LLCs can protect assets by removing the voting power of shares taken involuntarily from a member. This is an advanced topic and you should consult an attorney on how to use LLCs for asset protection.

Protecting Limited Liability of Single Member LLCs

Some people believe that if you're a single member LLC, there is no need for an operating agreement. Afterall, the operating agreement is essentially a contract among members as to how they'll run the company. Why would you need a contract with yourself?

However, an operating agreement is useful because it can help preserve your company's limited liability status. If you operate your single member LLC without an operating agreement, then your business begins to look very similar to a sole proprietorship.

If that happens, then a judge could pierce your corporate veil under the alter ego theory, holding that your LLC and you as an individual are actually one and the same.

With a formal operating agreement, you make it clear that you as an individual and the LLC are two separate entities.

How to Write an Operating Agreement

Most online incorporation companies include a basic operating agreement for your LLC as part of the package.

Other Operating Agreement Articles of Interest

Do you need an attorney to draft your operating agreement?
Find out when your situation requires an attorney, and when you can use a low-cost template or "semi-custom" operating agreement.

How to choose an incorporation company.

Ask A Question About LLC Operating Agreements

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