Limited liability companies, or LLCs, are business entities that protect your personal assets from business debts and creditors. They also allow for a less rigid structure and formality than other forms of businesses, particularly corporations. When forming an LLC, the operating agreement is a critical document. At its simplest form, it is a contract between each member of the LLC and it describes each member’s rights and duties to the other members and the business itself.
A simple operating agreement should set forth the ownership percentages of each member of the LLC as well as details about the LLC's purpose, members' duties and responsibilities, and member contributions and distributions.
Contents of an Operating Agreement
The specific contents of an operating agreement vary from business to business and should be customized to meet your business's needs. Simple LLC operating agreements describe each member’s ownership percentage, often based on the member’s respective financial contribution to the LLC; voting rights for making business decisions; how profits are distributed; the duties of each member; and the procedure for dissolving the business.
For example, a simple operating agreement provision describing distribution of profits might read like this: "The LLC will distribute profits to each member of the LLC on a calendar quarterly basis, starting March 31 each year. The distribution is based on a member’s respective ownership percentage."
Requirements for an Operating Agreement
Not all states require LLCs to have operating agreements. Even though the agreement may not be required, it is a good idea to have one. The operating agreement is clear evidence of each business owner’s intent as it applies to how the business is going to be run. If an argument arises among the members, the operating agreement is the first place to look to determine how it should be resolved. An operating agreement can mitigate disputes and potentially avoid legal action, which can save the business time and money.
LLCs can be single-member LLCs, which start with only one owner. They can also be multimember organizations. In a single-member LLC, the sole owner has the rights to all profits; they aren’t divided. In multimember LLCs, profits are split among the members, based on what is described in the operating agreement – or according to state law, if no operating agreement exists.
A common question involves family businesses run as LLCs. Imagine a restaurant started and owned by Grandpa Jim. Grandpa Jim is the sole member of the LLC, but he hires his grandson as a general manager. Even though Grandpa Jim’s grandson is related to Grandpa Jim and employed by him, in this example he is still an employee, entitled only to his salary.
Now imagine that Grandpa Jim offers his grandson the opportunity to be a member in his LLC. Doing so now entitles Grandpa Jim’s grandson to the benefits of being an owner, and those benefits should be clearly described in the operating agreement.
Changes to the Operating Agreement
Contracts, by nature, are flexible documents, and they can change. An operating agreement is a form of contract, so it, too, can change. If carefully drafted, the operating agreement should describe the process for amendment. Generally, it requires consensus from members. An amendment then needs to be written and filed with the secretary of state. While operating agreements typically do not have to be filed, amendments do, and therefore they become public records.