What is an operating agreement and do I need one?

An operating agreement is the document that memorializes the manner in which the members of a limited liability company (LLC) will govern themselves and manage the company’s affairs. The agreement defines the LLC’s business and the financial and managerial roles of its members. The operating agreement can contain anything its members believe is necessary to frame their rights and responsibilities, but it must be consistent with state law and the articles of organization forming the company.

Any company with more than one owner should have an operating agreement. An operating agreement is necessary for several reasons. First, an operating agreement becomes a formal and enforceable agreement that can protect the company’s limited liability status. Implementing the agreement adds to the weight that the company is neither a sole proprietorship nor a partnership, and therefore should be treated as the distinct and separate entity that it is.

In some states, an oral agreement may create a valid operating agreement; however, given the complexity of a typical operating agreement, it is a good idea to put the agreement in writing for the review and approval of all members. This avoids misunderstandings that may arise among the members. More importantly, the written agreement can be referenced in the event of any conflict to guide the members’ actions in resolving a dispute.

Lastly, if a business does not adopt an operating agreement, state default rules will govern. This means that state law will prescribe how decisions will be made in a business. In some cases, state law may also provide what happens if a member dies or desires to withdraw from the company. The default rules in most states are unfavorable and lack clarity. They are simply too general for most business purposes. As example, the following outlines the some of the default rules in the State of Oregon.

Under Oregon law, a member of a member-managed LLC and a manager of a manager-managed LLC have equal rights in the management and conduct of the LLC’s business and a majority of members or managers, respectively, can decide any matter related to the company’s business. This works in many instances, but it lacks the sophistication of a tailored operating agreement, which may provide certain members or managers authority to perform certain tasks, while limiting the authority of others. This also means that members and managers can bind their companies in the course of business without requiring approval of other members and managers, which could be contrary to the company’s intent and interests.

Oregon law does call out certain items that require unanimous consent of the members. These include amendment of the operating agreement or the articles of organization, compromise of an obligation to make a contribution or to return money or other property paid or distributed in violation, and dissolution of the LLC. These are issues that should be decided by a united front of the members, but there may be other instances where unanimous agreement is warranted—for example, changing the focus of the business or indebting the company in excess of a particular amount. In some cases, it may make sense to have a more flexible operating agreement and only require majority to approve changes. This may be particularly true of a larger company.

Pursuant to Oregon law, a majority of members must consent to the following actions:

  • Making interim distributions, including the redemption of an interest;
  • Admitting a new member;
  • Using LLC property to redeem an interest subject to a charging order;
  • Transferring or otherwise disposing of all or substantially all of the LLC’s property;
  • Merging the LLC with another entity;
  • Converting the LLC to another entity type;
  • Incurring indebtedness by the LLC other than in the ordinary course of the business;
  • Conflicts of interest between a member or a manager and the LLC;
  • Changing the nature of the LLC’s business; and
  • Deciding any other matter specified as requiring member approval if no number or percentage of members is otherwise stated.

As above, an LLC may want more flexibility to address some of these topics, or it may wish to further limit the approval of such actions to unanimous consent.

In sum, an LLC should establish a written operating agreement to define the governance and management of the members. This avoids the undesirable result of state default rules.