What is an LLC Operating Agreement?
In short, an LLC operating agreement outlines business processes and procedures for how business operations will be managed, as well as how situations should be handled if they arise; it is a legal document that governs the business. This ensures everyone involved understands, and accepts, their responsiblity with expectations understood. There are generally 8 sections of an operating agreement, but keep in mind there can be many subsections to elaborate on each area as necessary. Many, but not all, states require LLCs to maintain an operating agreement.
1. Company Formation
2. Capital Contributions
3. Profits, Losses & Distributions
Section 1 - Company Formation
There are several sub-sections to the company formation heading. A standard LLC operating agreement should include the following:
1.1 Business Formation
1.2 Registered Agent For The Business
1.3 Term of Business Duration
1.4 Purpose of the Business 1.5 Primary Location of the Business
1.6 Members of the Company
This is a one or two sentence statement addressing where the members have incorporated the LLC, and when (the date) the agreement will be take affect.
Registered Agent For The Business
You can articulate who the registered agent is, with their name and where they are located, or you can provide guidance on where to find this information. To avoid having to update multiple documents, since this is stated in the formation documentation when you become an LLC, it is suggested to refer to the formation document.
Term of Business Duration
Here you will state the intended duration of the company and provide subsection guidance with details on how to handle; 1) vested membership as it related to voting for the continuation of the business, 2) how to handle loss of members due to bankruptcy, death, resignation, retirement, etc., and 3) other factors that may lead to dissolution of the business.
You will also want to provide direction on remaining members authority in the event of members parting, define members rights for voting and decision making, and establish how many days remaining members have to vote on whether or not the business should continue to operate (in the event of member loss).
Purpose of the Business
One or two sentence statement that addresses performance expectations of the business. For example, the business will follow laws, regulations, and policies as set forth by the laws of the state it is operating within, with the intention of fulfilling business objectives.
Primary Location of the Business
Similar to the statement of who the LLC registered agent will be, you can articulate where the business will operate in this section OR you can refer to the formation documentation since location of operations will be listed there. You may also want to provide management authority (with voting discretion) on decisions related to relocation of the business if management deems it necessary for growth and sustainability.
Members of the Business
This section can state who the members are, or you can refer readers to an Exhibit. It is also important to state the process of including new membership.
Section 2 - Capital Contributions
In this subsection you will want to identify the contributing members of the LLC and how much each contributed. You can either articulate this information in this area, or refer readers to an Exhibit. It is also important to state whether or not additional contributions will be expected, and if so, how much and when. If no additional contributions are expected, then state so in this section.
Section 3 - Profits, Losses and Distributions
This section of your operating agreement will have two categories addressing; 1) Profits and Losses, and 2) Distributions of profits. Typically profits and losses are proportionately shared based on contribution distribution, however there may be cases where this is not the case. It is important to clearly define what percentage of the profits and losses will belong to each member. Also identify when the profit/loss will be calculated.
Distributions should be referenced to identify how they will be shared among the members, or determine a process for evaluating what should be done with available funds once expenses and liability obligations have been met. It is also important to discuss how negative account balances will be handled if there is a shortage of cash.
Section 4 - Management
This area will dig into the details of how members will delegate management responsibilities, as well as the extent of managerial authority for decision making. This heading will have several sub-sections:
1. Business Management
2. Member Responsibiliity
3. Managerial Power/Authority
4. Chief Executive Management (if present
5. Company Information
8. Managerial Responsibility for Record Maintenance
This subsection provides guidance on how to elect managers and the scope of responsibility for members, and elected managers. This area will address how many managers will hold a position in the business, and whether or not there will be a senior manager (Chief Executive Manager). Those that are placed into a position of management should be identified either in this section, or in an Exhibit.
Here you will adddress a broad overview of the scope and extent of liability for elected managers, as well as the scope of responsibility for members of the LLC. This section is used to provide separation of "power" for business decision making and where the responsbility rests.
Managerial power articulates specific details on decision making; such as control of assets, purchase/acquisition of assets, borrowing for business development/growth, and hiring/termination of employees that may be brought into the company. You will also want to articulate the scope of managerial responsibility as related to contracts, agreements, leases, promisory notes/loans, or other financial decisions. It is important to address the details of daily operations and who will bear the responsibility. If members are to maintain minimal liability, full managerial responsbility needs to be identified and granted to named managers.
Chief Executive Manager
If present or elected, the operating agreement should define how much authority the Chief Executive Manager bears. Do they own all responsibility with decisions made by managers, or do they provide oversight to ensure strong business decisions are made.
This sub-section articulates authority of members, and authorizes them (or their representatives) to seek and obtain all pertinent information related to the LLC with respect to record keeping and business activities. Financial impact of such requests should be identified as well (who will bear the financial burden of the requests?).
This is an "error or omissions" clause to release the manager for bearing liability in the event of a loss or damage to the company, as long as the manager made a good faith effort to operate, and make business decisions, that were in the best interest of the business.
This is a legal clause that provides details on how legal proceedings will be handled. This allows the business to take legal action if necessary, against unlawful acts in accordance with laws and regulations. It also references the allocation of legal costs in the event legal action is taken. It is recommended that you seek legal consultation on how to write this particular section... or do thorough research on the language that is written in this section to ensure it is proper and lawful. In the event legal pursuit is necessary this is the clause that will be referenced, and it must be thorough.
Provide specfic guidance on what should be maintained at the place of operations (where the business is conducted); such as 1) Certificate of Formation and Operating Agreement (to include amendments), 2) financial records (such as taxes from previous years), and 3) financial statements that should be maintained for compliance purposes.
Section 5 - Compensation
Compensation is a section that references costs incurred by managers or members and reimbursement, whether it be for services, travel, or other business related expenses that are incurred.
Section 6 - Bookkeeping
Bookkeeping is critical to business operations, especially for compliance and auditing purposes. This section should identify the expectations of managers and what records should be maintained, articulating the importance of accuracy. If separate accounts are to be maintained for members, then this needs to be stated, as well as how distributions will be managed for those accounts. You will want to address how credit balances are dealt with, and if there are multiple member accounts (such as distribution and capital) provide depth to how these will be managed. Define record maintenance and when the books will close each year, along with management responsiblity for communicating the results to members of the limited liability company.
Section 7 - Transfers
This sub-section defines how members will transfer their ownership in the event they decide to part with the business. In specific, detail how a member should sell their interest and what value their interest will hold. For example, if a member decides to sell their ownership portion of the business, should they offer members first "dibs" or can they sell to external non-members?
Section 8 - Disolution
Dissolution of the business should provide guidance on rules of engagement for how the business will disolve if member(s) choose to do so. The rules of the dissolution should be set forth in this section to ensure there is an exit strategy documented. Debts and liabilities should be discussed in this section, to ensure they are handled accordingly with respect to any cash proceeds that may be available.
Visit LLC Operating Agreement Template for additional information and a variety of templates for LLC operating agreements.