6 Key Provisions in an LLC Operating Agreement

LLCs offer limited liability protection and pass-through taxation, making them the perfect choice for a growing business. Here, you’ll learn about an LLC’s operating agreement — the essential document that sets the rules for your company.

The Two Types of LLC Formation Documents

Let’s start with the basics. When you form an LLC, you’ll need to prepare two main formation documents:

Certificate of Formation

The Certificate of Formation (called Articles of Organization in some states) is a short document you must file with the local Secretary of State to legally form your LLC.

Certificate of Formation basics:

Filing fee: Yes
Publicly filed: Yes
Signatory: Organizer of LLC
Information required: Basic

You can file the Certificate of Formation yourself or have a registered agent or attorney file on your behalf. The filing fee can be as low as $50 and as high as $500, depending on the state. The information required is very limited — usually basic items the name of your LLC, your registered agent, and an address.

Operating Agreement

The Operating Agreement (also called an LLC Agreement) is where all the action happens. Signed by all the LLC’s equity holders (called “members”), the Operating Agreement touches on a wide range of corporate governance issues, from management of the LLC to admitting new members.

Operating Agreement basics:

Filing fee: No
Publicly filed: No
Signatory: All LLC members
Information required: Detailed

Preparing the Operating Agreement should be a careful and considered process. Ideally, you should hire an attorney to help guide you through all of the issues. Now, let’s explore the endlessly exciting world of LLC Operating Agreements.

The Essential Sections in an LLC Operating Agreement

Every Operating Agreement is different. A simple single-member LLC may have a two-page Operating Agreement, while a mature business with several classes of investors may require over 50 pages. However, most multi-member Operating Agreements touch on the following six issues.

1. Management Structure

LLCs are unique in that they can be either member-managed or manager-managed.

Member-Managed LLCs

In a member-managed LLC, the business’s owners are in charge of running the LLC. Typically, the Operating Agreement specifies a required percentage vote for various actions. The vote is usually based on each member’s percentage ownership in the LLC (the member’s “membership interest”).

For example, an Operating Agreement could provide for the following voting requirements:

51% of the membership interests for routine matters
75% of the membership interests to admit a new member
100% of the membership interests to dissolve the LLC

LLCs are flexible, so you can set up the voting structure however you’d like. Members can also delegate aspects of day-to-day management to officers like a Chief Executive Officer, Chief Financial Officer, and Secretary.

Manager-Managed LLCs

On the other hand, in a manager-managed LLC, the members appoint one or more managers to operate the business. Managers in an LLC are similar to a board of directors in a corporation.

While managers control many aspects of the business, Operating Agreements usually provide that the members keep the power to approve major decisions, such as:

Dissolving the LLC
Distributing profits
Replacing the manager

Managers can appoint officers to take care of routine business matters, just as with a member-managed LLC.

2. Controlling Who Can Become a Member

Many LLC Operating Agreements have detailed rules for admitting new members and transferring membership interests.

LLCs are often small businesses with limited equity holders. If you’ve formed an LLC with a few close friends or colleagues and have invested your time and money, you want to prevent the other members from selling their interests to outsiders without your consent. You don’t want to end up with someone you don’t trust as your business partner.

Restricting Transfers of Membership Interests

One way an Operating Agreement can control the admission of new members is by restricting the transfer of each member’s interest in the LLC. For example, an Operating Agreement could say that 100% of the members must approve any sale or other transfer of an LLC interest.

Another way to protect the membership is to include a right of first refusal in the Operating Agreement. Also called a ROFR, a right of first refusal requires that a member who has received an offer to sell his or her membership interest to an outside party must give the LLC’s existing members a chance to buy the interest — on the same terms — before selling to a non-member. Similar provisions like rights of first offer or preemptive rights also limit who can become a new member of the LLC.

Voting to Admit New Members

Many Operating Agreements require that the members approve a transferee (someone who bought the LLC interest from a member) before that transferee becomes a full member.

So, let’s say an LLC has three members: Member A, Member B, and Member C. After complying with the Operating Agreement’s right of first refusal provisions, Member A sold her interest to Outsider D.

However, before Outsider D becomes a full member in the LLC — including the right to vote and manage the business — Member B and Member C must approve outsider D with a vote. Otherwise, Outsider D is referred to as a “mere transferee” which has a financial interest in the LLC but doesn’t participate in management. After Member B and Member C vote to admit Outsider D, Outsider D magically becomes Member D.

3. Allocation of Profits and Losses

In a typical corporation, each shareholder receives profits proportional to the number of shares held (check out this article for more on the differences between LLCs and corporations).

In practice, LLCs often have a similar structure, allocating profits based on membership interest. However, the options available to LLCs are actually much more flexible, allowing members to creatively allocate profits and losses between the members.

For example, an Operating Agreement could provide that Member A and Member B each own 50% of the LLC. Each member has equal voting powers. However, when it comes to profits and losses, 70% are allocated to Member A and 30% to Member B.

You can get pretty fancy with allocations, pulling various levers to create an Operating Agreement that makes everyone happy. For instance, a high-income member may want to be allocated a large share of losses to reduce his or her tax burden.

However, the IRS won’t always permit these special allocations. It’s essential to consult with a knowledgeable tax attorney before getting too out of control with unusual terms regarding the allocation of profits and losses. Safety first.

4. Distributions to the Members

Once you’ve decided how to allocate the LLC’s profits, the Operating Agreement should spell out how to distribute cash and other assets to the members.

A relatively simple Operating Agreement may require a certain percentage vote by the members to distribute funds pro rata based on each member’s interest in the LLC. The document might also have a mechanism for valuing the distribution property that isn’t cash, called in-kind distributions. Examples of in-kind distributions include securities, real estate, or cryptocurrency.

If an LLC has various classes of members, each with their own rights and preferences, the Operating Agreement might be much more complex, creating a distribution waterfall that pays some investors before others.

5. Indemnification of Members, Managers, and Officers

The United States is a litigious society. Lawsuits appear left and right, sometimes out of thin air! To help protect LLC executives, many Operating Agreements indemnify members, managers, and officers for losses incurred as a result of actions taken on behalf of the company.

The last sentence was a little complex. Let’s back it up and slow it down.

The Dangers of Being an LLC Manager

Let’s say you’re the manager of an LLC. In the course of your duties, you make various choices. You might make public statements about the company, hire a delivery driver, and choose a new salad dressing for the business’s cafeteria.

All of these decisions could end up in a disaster. Perhaps the SEC isn’t happy with your public statements. The delivery driver accidentally strikes a pedestrian. Several employees come down with salad dressing-related food poisoning. Everyone sues you. Cue the tiny violin.

Being a business executive makes you the target of lawsuits, legitimate and frivolous. To help encourage capable people to join management, LLCs (and other businesses) often indemnify managers, officers, and members.

Indemnification — Covering Business-Related Losses

Indemnification means the LLC will pay you back for the legal costs associated with the salad dressing lawsuit. In fact, Operating Agreements often provide that the LLC will advance legal costs to you ahead of time.

The LLC may also reimburse you for losses that aren’t specifically lawsuit-related. Basically, indemnification helps encourage high-quality workers to take the risk of becoming a manager or other executive.

Limits to Indemnification

However, indemnification has its limits. Usually, Operating Agreements won’t indemnify executives who acted in bad faith, gained an improper benefit, or knowingly violated the law.

Plus, indemnification only applies to acts performed in the course of business. So, an LLC may indemnify its CEO for business decisions made on the job, but not for shoplifting a Slurpee from 7-11.

6. Dissolving the LLC and Winding Up the Business

Perhaps the business didn’t work out after all. Or, maybe you and the other members made so much money that you want to close up shop and spend your remaining days sipping Mai Tais in Curaçao.

Either way, at some point, the LLC’s life may come to an end.

Your Operating Agreement should specify reasons why the LLC might be dissolved, such as:

A vote of the members
Pursuant to a court order
There aren’t any members left
The LLC’s purpose is over (such as the end of a fund’s term)

In addition, Operating Agreements typically provide for how the assets of the LLC should be distributed.

For example, funds might be used in the following order:

Pay costs of dissolution
Pay off third-party lenders
Pay off members who loaned money to the LLC
Distribute remaining profits to the members

You probably aren’t starting a business with plans to shut it down, but preparing for the unexpected is what an LLC’s Operating Agreement is all about. By talking through the issues and negotiating up front, you and the other members can prevent headaches down the road.

Get Help Drafting Your LLC’s Operating Agreement

LLCs empower you to customize your business to fit your needs. With great power comes great responsibility. It’s essential to take the time to talk through all of the aspects of your LLC’s Operating Agreement and make sure the document reflects your preferences and expectations.

If you need help drafting your LLC’s Operating Agreement — or have other questions about starting, growing, or protecting your business — feel free to reach out.