Anatomy of an Operating Agreement Part 1: What Are the Basic Parts of an Operating Agreement?

As discussed in a previous post, operating agreements are a fundamental founding document for an LLC. The beauty of an operating agreement is that it can be extraordinarily flexible to accommodate almost limitless options to suit the specific needs of any business and its owners. The agreement can also be modified to respond to changes in the business over time. With that in mind, operating agreements should contain several basic items.

The Business Itself
An operating agreement should contain information regarding the business, often an elaboration of the information submitted to the state in the formation articles. The operating agreement should declare the name of the LLC, the date of its formation and its duration, the LLC’s purpose, and the LLC’s place of business and contact information. This information is important to include as foundational aspects of the business.

Members, Ownership Interests, and Distributions
The operating agreement should contain the names and addresses of the members, a recording of the capital contribution of each member, and the percentage of ownership for each member. Often, the percentage of ownership mirrors the proportions of capital contributions, but it need not be divided this way. Ownership can account for non-monetary donations to the company, such as sweat equity.

In addition to establishing ownership interests, an operating agreement should define how profits and losses are to be shared among members. This may correspond directly to the ownership interest or it may follow some other mechanism as agreed upon by the members. The operating agreement should also address how and when distributions will occur and how the LLC’s income taxes will be paid. It would be wise to have a tax professional review your plan prior to execution to ensure its compliance with federal and state income tax reporting principles.

Meetings and Voting Rights
In smaller LLCs, especially where there are only two or three members, meetings are often an informal occasion. However, it is still important to define how a meeting should be called and how to give notice to the members. It is also important to provide for telephonic or electronic meetings if the members so desire this option, in addition to providing for making decisions without the requirement of a meeting. This is important because it will allow freedom on how you make decisions for the business. You may also want to include the ability for a member to name a proxy, in other words, give someone else the authority to vote on the member’s behalf. Depending on how ownership is shared among the members of the company, a simple majority for quorum may not make sense and you may wish to require two-thirds or three-quarters majority.

At this juncture, it is also important to consider how votes will be cast. Votes can either be assigned according to each member’s percentage of ownership or each member can have a single vote. It is most common to provide for votes in proportion to the members’ ownership interests. It is also appropriate to require unanimous consent for certain actions, particularly dissolution or substantial changes to the business.

By including these basic items in an operating agreement, members are able to govern themselves, avoid misunderstandings, and facilitate the smooth operation of the business.