Everything You Need to Know About Drafting an Operating Agreement for Your LLC

July 12th, 2019   |    By: The Startups Team

##What is an operating agreement?

An operating agreement is a legal document that outlines the financial rules, responsibilities of founders, how disputes are resolved, and even more of a limited liability corporation (LLC). Other business formations, like corporations, have articles of incorporation and corporate bylaws, which are similar to operating agreements but not the same. Basically, they’re the way you and your cofounders will outline everything you need to know and do in order to successfully run your startup.

While only California, Delaware, Maine, Missouri, and New York actually require that an LLC has an operating agreement, we very, very highly recommend drafting one, regardless of where you’re located. If you decide not to have an operating agreement or decide to only have a verbal operating agreement — again, not recommended — your company will be governed by your state's default rules. In most states, you also don’t have to file an operating agreement anywhere — just keep it on hand in a secure place for you and your cofounders to access if needed and make sure each member has their own, signed copy.

Operating agreements are also important because they protect you and your cofounders from disputes down the line. And disputes will happen.

“Our lack of a founders agreement left us unprotected and insecure, even though we had always trusted each other,” Feel Free founder Meghdad Abbaszadegan writes. “Feel Free was at its peak, but we were too terrified to move the company forward.”

A good thing to remember is that all legal contracts — be they between you and a freelancer or you and a client or even you and a spouse — exist for when things go wrong. Without an operating agreement, Meghdad quickly saw trust, friendship, and ultimately his startup dissolve.

“When you first start a company, it’s easy to forgo an operating cofounder agreement or other technicalities in favor of dreams and aspirations,” he writes. “It’s not until you achieve success that money and greed come into play. Entrepreneurs stop thinking about the vision of their companies and begin to think about themselves. When my cofounder and I fell victim to this, Feel Free changed from a success story to a nightmare.”

So how can you avoid Meghdad and Feel Free’s fate? Here’s everything you need to know to set up a solid operating agreement and get your startup on the road to success.

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##Sections your startup’s operating agreement needs to include

Operating agreements include a lot of information. And that’s good! Being thorough is what protects you, your cofounders, and ultimately your startup. While operating agreements can vary pretty widely from company to company, they generally include six sections: Organization, Management and Voting, Capital Contributions, Distributions, Membership Changes, and Dissolution.

Here’s a quick overview of what you might include in each section.

###Organization

The organization section is all about the start of your business. When was it created? Who are the members? What’s the ownership structure? You should also outline how many units of ownership each member has.

Equity Structure

This section of the operating agreement irons out exactly who’s going to own what part of the startup equity pie.

Membership Interest

This is where you determine what percentage of the company each member — i.e. you and your cofounders — own. This number can change as people join and leave the company. You should also figure out what percentage of management interest each member owns. That means you need to determine if each person is just an owner in an economic sense or if they also play an active role in management.

Classes of Membership Interest

What classes of membership interest do you and your cofounders have? Non-voting interests? Common interests? Preferred interests? Convertible interests? Profits interests? LLCs can have a range of capital structures, so this section is determined based on how you and your cofounders have decided to structure your startup.

###Management and Voting

Management

Who’s running the day-to-day of your startup? The managers. In some LLCs, all members are also managers. But in others, members hire employees to act as managers. Decide which you want and record it in this section.

You also need to determine how often you’ll have manager meetings and what they’ll look like, voting procedures, duties and responsibilities of managers, term, and how you’re going to go about firing and replacing managers, when and if the time comes.

Voting

Who’s going to be allowed to vote on company decisions? Who isn’t? What parts will they be able to vote on? Some LLCs give voting rights based on a member’s percentage interests, but others choose to give limited voting rights to certain groups. You can also give veto rights but no voting rights; supermajority votes; or even managerial rights but no voting rights.

###Capital Contributions

Every member of your LLC has a capital account, which is a general ledger account where the member’s contributed capital and earnings are recorded. In the case of an LLC, contributed capital can take the form of cash, property, services rendered, a promissory note, or some combination of the above or even a promise of one of the above.

If one of your members contributes something other than cash, you all need to figure out the monetary value of that thing and record it here. You also need to figure out whether members will continue to contribute capital throughout the life of the company or just at that initial investment.

###Distributions

Your LLC can default to proportionate allocation of profits, losses, and distributions — meaning each person gets exactly the same percentage as the percentage of their contribution — but you can also decide not to go that way. Depending on what you and your cofounders want you could, for example, say that the person who hold 50 percent of the percentage interest of your startup gets 75 percent of profits and losses. Whatever you decide, this section is where you need to clearly spell it out.

###Membership Changes

How are you going to add or remove members from your LLC? You also should spell out if and when members can transfer their ownership shares.

Anti-dilution Protections

This section is about protecting each member’s members interest percentage. It gives members the right to veto the issuing of new membership interests and admission of new members; limit capital calls; and the right to purchase any class of membership interest being offered in order to keep up their percentage interest.

Buyout

If a member of your LLC dies, becomes disabled, goes bankrupt, or is fired — what are you going to do? This section gives remaining members the option to buy out that member’s interests. If you do decided to include buyout rights, be sure to outline how a buyout would take place, the buyout price, and the payout terms.

If you’re stuck on buyout price because your company is still young, consider either setting a price now or writing a provision the price will be based on fair market value at the time of the buyout. Then, let that number be determined by an impartial third party appraiser.

###Dissolution

No one likes to think about the end at the beginning, but it’s best for everyone involved if you do. Outline what circumstances or events would lead to the dissolution of your LLC. You should also spell out winding up procedures and waterfall distributions of your company’s assets if your LLC dissolves.

##LLC operating agreements specifics (main usage for these types of businesses)

Your company’s operating agreement will also differ slightly depending on the type of LLC it is. Here’s an overview of what that looks like.

###Single Member LLC

It may seem silly for a single member LLC to have an operating agreement — who, after all, are you agreeing with? — but it’s actually important. That’s because operating agreements don’t just outline the relationships between members. They also outline the structure of the business itself.

For example, a single member LLC operating agreement should include the parts of the Organization, Distribution, and Dissolution sections, above, that are relevant to a single member LLC. It also establishes that you, the individual, are legally separate from the LLC, even if you’re the only member of it. That separation protects you from legal and financial liability should something go wrong with your company.

###Two Member or Multi-Member LLC

For LLCs that have more than one member, you’re going to need a multimember LLC operating agreement. You have two options here: multimember member-managed LLC operating agreement or manager-managed operating agreement. The difference is whether you and your cofounders will be involved in the day-to-day operation of the company. If that’s the case, go with the former. If not, go with the latter.

##How to handle amendments or changes to your operating agreement

An operating agreement should be a living document, which means it’s never actually “done.” You’ll find at times that you need to make amendments or changes to it.

Here are some circumstances that can trigger a change to your operating agreement: -You’ve changed distribution timing -You’ve added more capital -You’ve added a member -A member has left -You’ve changed from member-managed to manager-managed, or vice cersa -You make any big managerial or financial changes -You want to change the percentage allocation of the distributions

###How to change your operating agreement

In most cases, making the changes to your operating agreement is surprisingly easy! Simply make the changes and get documented approval from all members.

You also may have outlined a process for making changes in your original operating agreement. If that’s the case, follow that procedure or the changes you make might not be valid.

##Where can you find operating agreement templates?

While you can certainly prepare an operating agreement yourself — and we’ve included some sample templates, below — it’s always a good idea to have a lawyer look over your operating agreement before you and your cofounders sign it. This is one of those cases where even bootstrapping founders should just spend the money, because if you make a legal mistake in your operating agreement, it could be devastating for you and your cofounders down the line.

###Operating Agreement Templates

Here are some great operating agreement templates to help you get started.

LawDepot

LawDepot offers operating agreement templates based on your state, so you can make sure you’re following all the local rules and regulations.

RocketLawyer

RocketLawyer also offers [operating agreement templates based on your state[(https://www.rocketlawyer.com/form/llc-operating-agreement.rl#/), as well as the option to legally sign your final agreement right on their site.

Harvard Business School

Check out this Harvard Business School member-managed operating agreement, which already has a lot of the important legal stuff filled in.

###Operating Agreement Samples

If you’re the kind of person who likes to work from example, here are some operating agreement samples for you to check out.

Score

Score offers this Sample LLC Operating Agreement to give you an idea of what a finalized one can look like.

Northwest Registered Agent

Northwest Registered Agent offers both a template and an editable sample to help new business owners develop their operating agreements.

##Want to know more?

Curious about other types of business formations? LLCs aren’t the only way to go! Don’t miss these Startups.com guides.

What is a Corp? S Corp [What is a C Corp(https://www.startups.com/library/expert-advice/what-is-a-c-corp) [What is a B Corp?](https://www.startups.com/library/expert-advice/what-is-a-b-corp) [Limited Liability Companies (LLC’s): What You Need to Know](https://www.startups.com/library/expert-advice/limited-liability-company-llc) [What is a Limited Partnership?](https://www.startups.com/library/expert-advice/limited-partnership) [Everything You Need to Know About Forming An LTD](https://www.startups.com/library/expert-advice/forming-a-ltd(https://www.startups.com/library/expert-advice/inc-business-formation)

About the Author

The Startups Team

Startups is the world's largest startup platform, helping over 1 million startup companies find customers, funding, mentors, and world-class education.

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