What is an Operating Agreement?
by Nicole Rash
June 3, 2022 — An operating agreement is a legally binding contract between the members of a limited liability company (LLC). It is used to outline how the company is managed, who has membership interests, the distribution of profits and losses, and the dissolution of assets. The purpose of the document is to govern the internal affairs of the business in a way that suits both the specific needs of the business owners and the overall company. A properly constructed operating agreement will help your company avoid potential conflicts as your business develops.
There are many free operating agreement templates on the internet, but they can be difficult to tailor to your specific business needs, especially in highly regulated markets, such as the cannabis industry. While the state of Washington does not require you to file any operating agreement with the State, if you decide to skip this step, then you and your business would be subject to the default Washington laws to sort out conflicts within the LLC, which falls to the Washington Limited Liability Company Act – RCW 25.15. Because state laws and regulation do not always serve the best interests of the business, creating a personalized operating agreement is imperative to avoid these problems if conflicts do arise. Companies have a lot of freedom to decide how extensive they would like their operating agreements to be and how growth will be accommodated. Below are some sections to include in a well-constructed operating agreement:
Information included in this section are the parties, background, and organizational matters. Upfront matters include whether the LLC will be manager-managed or member-managed, if it will be single-member or multi-member, and whether the LLC will use a detailed long form or a simple short form agreement.
Essential elements in this section include:
- Name of LLC
- LLC Purpose
- Date of Formation
- Principal Place of Business
- Name and Address of Registered Agent
- Name and Address of Tax Partnership Representative
Member and/or Manager Considerations:
This section of the operating agreement allows the members to determine control of the LLC. Depending on whether your LLC is manager-managed or member-managed, the operating agreement should consider how new members or managers will be admitted after formation, and what happens upon termination or removal of a member or manager. A member-manager LLC generally allows the LLC’s members to bind the LLC in contracts and agreements as well as take part in day-to-day operations. Whereas, a manager-managed LLC designates to one or a few managers the ability to bind the LLC in contracts and agreements and limits members to certain rights or duties. Essential elements of this section include:
- Whether and how interests will be transferred,
- Dissolution provisions including buy-sell options,
- How annual meetings will occur, or if they occur,
- Voting rights for each class of member or manager.
- Decision making
- Manager elections
- Whether there are different classes of members
- Whether members have the right to engage in competing businesses
- Indemnification for members, managers, and different classes
Companies will have to determine if additional contributions are required of all members and the form and amount of the member’s contributions. Companies must also decide on who can make capital calls and how the process works. Essential elements of this section include:
- Capital contributions
- Capital accounts
- Allocations and distributions
Taxes, Books and Record:
The operating agreement should determine how the LLC will be treated for US federal income tax purposes. Unless an LLC specifically elects to be treated as a corporation, it is generally treated as a pass-through entity that it is not itself subject to tax. LLCs could also include recordkeeping and informational rights.
Dissolution and Winding Up:
LLCs should lay out the process of dissolution of the company. This provision should answer the question of how assets will be distributed to the members, how liabilities are paid and to whom, and how should non-cash assets, including intellectual property, be dispersed.
Every LLC has different goals upon dissolution which requires different provisions. Operating agreements are intricate and time consuming to create, but can save time, money, and frustration if conflicts do arise. If you’re interested in learning more or would like to discuss strategies and provisions that would best suit you and your company’s needs, Gleam Law. With offices in Seattle, Portland, Denver, Phoenix, San Francisco, Los Angeles, New York, Hoboken, and Raleigh Durham, Gleam Law business lawyers can help you navigate the legal landscape!