Startup Formation 101: What is an Operating Agreement and do I need one for my LLC?

The short answer is yes – you need one if you have an LLC.

This is the first in a series of practical startup formation questions that are faced by startups everywhere.

Operating Agreements vs Bylaws vs Certificate of Formation

Before we get into the details of an Operating Agreement we first need to back up a second and determine what type of entity you are forming. There are two basic entity types when it comes to state formations. The first is and limited liability company (LLC) and the second is a corporate form of doing business. These have varying tax ramifications but also have different structures and compliance requirements.

An Operating Agreement is associated with an LLC whereas Bylaws are associated with Corporations. The third term that enters that enters into the picture is the Certificate of Formation, sometimes called the Articles of Incorporation. These are not to be confused with an Operating Agreement as these are public documents that are filed with the State upon the creation of the LLC or Corporation.

Operating Agreements

Operating agreements are a private document prepared by LLC’s to outline ownership, management and financial operational matters. Some states such as Delaware and California do require LLC’s to have a written operating agreement, others do not.

A couple key points in the construction of a Operating Agreement are as follows:

• Reinforce liability protection. Take the opportunity to emphasize in the Operating Agreement that the entity stands independent of its members and the liability stops at the entity level. The LLC, by its nature gives that protection, but reinforcing this in the Operating Agreement can only help in a difficult situation.
• Multi member disputes. Clarifying who owns what share of the business and how those units are transferred in the future is also important. That is why the Operating Agreement should be done early in the formation so that everything is clear from the onset of the startup. Dispute resolution should be added to the the document to help resolve and contain a dispute amongst members.
• Management structure. The definition of roles and responsibilities and outlining the decision making process in the Operating Agreement will eliminate friction between members and give clear guidance on responsibilities in the future.
• Living document. There are multiple changes that happen to an entity along the way and the Operating Agreement should be referenced to accommodate those changes through periodic amendments.

How To Construct an Operating Agreement

Remember the Operating Agreement is a high level document and not a detailed manual of every policy and procedure in the company. After you have reviewed the State requirements you have a few options:

1. You can use state specific templates that can be located online on various secretary of state sites or other online sources.
2. You can use various commercially available software programs to construct your own.
3. Preferred. I would suggest you do the hard work using 1 or 2 and then have it reviewed by an attorney familiar with the particular state in which you have formed the LLC. The attorney probably will not like that as each likes to use there own format so get prepared to see some changes.