What Is an LLC Operating Agreement?
The Delaware legislature created the limited liability company (LLC) in such a way as to allow the LLC's members the freedom to contract with one another upon whatever terms they deem are best suited to their company.
In a corporation, for example, Delaware law requires certain terms to be included in the corporation’s constituent document and mandates certain provisions related to corporate governance are followed; it also limits (to some extent) the ability of the parties involved to modify certain terms relating to voting or fiduciary obligations.
In an LLC, however, the members are free to organize the LLC in any manner they choose, with near-total freedom to define the relationship among the members as well as the terms governing the operation, oversight and maintenance of the LLC.
The fundamental terms of an LLC’s ownership, operation and management are set forth in its LLC Operating Agreement.
So, what is an LLC Operating Agreement?
An Operating Agreement can be a written document or merely an oral understanding. A written agreement, however, is typically used because it memorializes the understanding and agreements between the members which, in the event of a future dispute or misunderstanding (or the unfortunate possibility of litigation), is invaluable protection for all parties involved.
Although each LLC Operating Agreement is different, it should generally set forth certain fundamental terms.
7 key items commonly addressed in an LLC Operating Agreement:
- Classes of Interests
For various business, legal or tax reasons, LLCs may issue classes of LLC interests. Different classes may have differing rights with regard to any aspect of an LLC’s business or operations, including economic rights, voting rights and rights to distributions from the company.
- Economic Rights & Distributions
The Operating Agreement may set forth how economic profits and losses are allocated among the members and how and when distributions will be made. The amount and timing of distributions can be set at management's discretion, required at established times or triggered by certain events. LLC Operating Agreements sometimes include both required and discretionary distributions.
- Management
The Operating Agreement may set forth how the LLC is managed. An LLC can be managed by one or more members; by a board of persons (composed of members and/or non-members); or by one or more appointed managers. Generally, management is responsible for strategic decisions and the day-to-day running of the business, subject to any predefined limitations.
Management-related provisions commonly found in an LLC Operating Agreement include:- Appointment of the initial members of management.
- Procedures or triggers for removing or replacing management.
- The powers of management (frequently a broad list of permitted actions)
- Limitations on management’s authority, such as a requirement that members representing a certain percentage of interests (individually or in the aggregate) pre-approve certain actions.
- Fiduciary Duties
Parties in an LLC Operating Agreement can waive or otherwise modify the traditional fiduciary duties of care and loyalty that may otherwise be imposed by default, as opposed to in a corporation. The practical effect of fiduciary duties is the subject of a significant body of case law, and language in an LLC Operating Agreement can be a primary determinant of the outcome of litigation among members of the LLC.
- Raising Additional Capital & Admitting Additional Members
An LLC may require additional working capital in the future. The procedures for raising supplemental funds (either from existing members or by accepting new investors) are generally spelled out in the Operating Agreement.
- Transfer of Interest or Withdrawal from LLC
An LLC Operating Agreement often describes when, and under what conditions, a member may transfer his/her interest in the LLC, including for estate planning purposes. Similarly, the Operating Agreement may set forth the process and permitted circumstances under which a member may withdraw from the LLC prior to its cancellation; however, such a withdrawal, if permitted, is frequently subject to significant conditions and limitations.
Often, a permitted transfer or withdrawal will trigger a right of first refusal, permitting the other members to acquire the interest at issue on such terms as are set forth in the Operating Agreement.
- Cancellation
An LLC Operating Agreement often states the events or votes which will trigger the winding up and cancellation of the LLC, and typically details how any LLC assets will be distributed after the discharge of all its liabilities.
In addition, make sure your Operating Agreement is clear on these fundamental matters:
- The ownership percentage of each member
- The impact of the death or disability of a member
- Indemnification rights (if any) in the event the LLC (or a member) is sued in connection with the LLC's business
In Delaware, your LLC Operating Agreement is an internal document.
There are numerous benefits to a Delaware LLC. One of the most popular aspects is that the state of Delaware does not require a Delaware LLC's Operating Agreement to be filed or made public, as some other states do; thus your Delaware LLC's Operating Agreement remains completely private among you and your fellow LLC members.
A Delaware LLC is typically formed by filing a Certificate of Formation with the state, which includes only the name of the LLC and the office of the Registered Agent, which allows all the members of your LLC to remain private.
Next: Free Operating Agreement Templates
*Disclaimer*: Harvard Business Services, Inc. is neither a law firm nor an accounting firm and, even in cases where the author is an attorney, or a tax professional, nothing in this article constitutes legal or tax advice. This article provides general commentary on, and analysis of, the subject addressed. We strongly advise that you consult an attorney or tax professional to receive legal or tax guidance tailored to your specific circumstances. Any action taken or not taken based on this article is at your own risk. If an article cites or provides a link to third-party sources or websites, Harvard Business Services, Inc. is not responsible for and makes no representations regarding such source’s content or accuracy. Opinions expressed in this article do not necessarily reflect those of Harvard Business Services, Inc.
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There are 6 comments left for What Is an LLC Operating Agreement?
Ken V said: Thursday, December 12, 2019I own units in a Three Member Class Delaware LLC. There are A, B and C units. My Units are C provided by options that have vested as a former employee. The Board will not provide me with a copy of the LLC Agreement, however, they continue to tell me what rights I do not have per the Agreement. They are now saying since I am contesting the last 2 years audits they do not have to provide me with any financial information going forward and have instructed the auditors not to answer my questions. What parts of the Delaware Act override these issues. Thank you in advance for your help. Ken
HBS Staff replied: Friday, December 13, 2019Ken, we are unfortunately unable to advise on legal matters. However, we can refer you to the Delaware LLC act Title 6, chapter 18-305 which discusses member rights: https://delcode.delaware.gov/title6/c018/sc03/index.shtml. We encourage you to consult an attorney to interpret how this may apply to your specific situation.
Gustavo said: Wednesday, May 29, 2019We made an operating l agreement when the LLC was created , and sent a copy to our bank informing who were the members certificate of formation - We change the members this year shoud we make new operation agreement including only the active members ? Thanks
HBS Staff replied: Thursday, May 30, 2019Gustavo, typically clients will update their operating agreement whenever there are ownership changes in the LLC. This document is not filed with us or with the state of Delaware. You may want to contact your bank and see if they require an updated copy of the agreement.
Sebastian said: Monday, February 11, 2019Would all members of an LLC need to have the same Operating Agreement, or can the Operating Agreement's T&C's be negotiated differently with each member?
HBS Staff replied: Monday, February 11, 2019Sebastian - In general, members are free to organize the LLC in any manner they choose, with near-total freedom to define the relationship among the members as well as the terms governing the operation, oversight and maintenance of the LLC. If you have additional questions, feel free to chat with us. You may also want to consult an attorney for specific matter related to your LLC.
Rosemary Remington-dec. Moore said: Saturday, November 3, 2018Thanks so very much for the LLC package within my Rosemary Remington-dec. Moore Irrevocable Trust, a Delaware Statutory Trust. I am very much looking forward toward being in business more formally!
HBS Staff replied: Monday, November 5, 2018It was our pleasure to help you, Rosemary! Please let us know if you have any questions going forward.
Marcus Franco said: Wednesday, March 28, 2018Hi is it possible to change a delaware llc from a single member to manager managed
HBS Staff replied: Thursday, March 29, 2018Hello. Information such as the member(s) name, address and the percentage of the business owned is not required to be provided to the state of Delaware and therefore is not part of the public record. This information is kept on file internally within the LLC's Operating Agreement.
The LLC's Operating Agreement can be altered as needed by the members, without filing the changes with the state of Delaware. Some of the typical changes people make are the removal or addition of a member or the change in percentage of a member's ownership.
More details here: https://www.delawareinc.com/blog/change-of-ownership-for-an-llc/
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