LLC Operating Agreement: Essential Clauses & State Guide

One document determines whether your business thrives through challenges or collapses into costly litigation: your operating agreement.

Most entrepreneurs skip this step or download a generic template without understanding what they’re signing. That’s a mistake. While most states don’t legally require operating agreements, the absence of one can destroy your limited liability protection, trigger IRS audits, create partnership conflicts that kill businesses, and leave you vulnerable during member disputes, divorces, or deaths.

This guide explains exactly what belongs in an LLC operating agreement, how single-member and multi-member agreements differ, which states mandate written agreements, and the critical mistakes that make operating agreements unenforceable in court.

The Quick Answer: What Must Every Operating Agreement Include?

Essential clauses for all LLCs (single and multi-member):

• Company name, formation state, and principal business address
• Statement of purpose and duration
• Registered agent information
• Member names, addresses, and ownership percentages
• Initial capital contributions (cash, property, or services)
• Profit and loss allocation method
• Distribution timing and approval requirements
• Management structure (member-managed vs manager-managed)
• Fiscal year end date
• Books and records requirements
• Dissolution and winding-up procedures
• Amendment procedures
• Governing law and jurisdiction

Additional clauses required for multi-member LLCs:

• Voting rights and decision-making thresholds
• Transfer restrictions and consent requirements
• Right of first refusal for member buyouts
• Buy-sell provisions for death, disability, bankruptcy, divorce
• Valuation methods for ownership interests
• Admission of new members procedure
• Member withdrawal terms
• Dispute resolution and mediation clauses

The test: If your operating agreement doesn’t answer “who decides, who owns what, and what happens when someone leaves,” it’s incomplete and won’t protect you when problems arise.

What Is an LLC Operating Agreement?

An LLC operating agreement is a legal contract among the members (owners) of a limited liability company that establishes the rules for how the business will be owned, managed, and operated. Think of it as your LLC’s internal constitution, a private document that governs relationships among members and between members and the company itself.

Unlike your Articles of Organization (the public filing that legally creates your LLC with the state), your operating agreement isn’t filed with any government agency. It remains private among members, although banks, lenders, and investors will often request copies.

Why You Absolutely Need One (Even If Your State Doesn’t Require It)

1. Protects Your Limited Liability Status

The primary reason to form an LLC is limiting personal liability, which shields your home, car, and savings from business debts and lawsuits. But courts can “pierce the corporate veil” and hold you personally liable if they believe your LLC is merely your alter ego rather than a legitimate separate entity.

An operating agreement is critical evidence that your LLC is a real business with formal governance, not just you operating under a different name. Courts specifically look for:

• Written operating procedures separate from your personal whims
• Documented capital contributions and distributions
• Evidence of following your own rules
• Clear separation between personal and business activities

Without an operating agreement, judges are far more likely to treat your LLC as a disregarded entity and expose your personal assets.

2. Overrides One-Size-Fits-All State Default Rules

Every state has default LLC statutes that automatically apply if you don’t create your own rules. These defaults often conflict with what members actually want:

• Profit sharing: Many states default to equal distribution regardless of ownership percentage. If Member A contributes 90% of capital and Member B contributes 10%, profits might still be split 50/50 under default law.

• Voting rights: Some states give one vote per member regardless of ownership stake. Your 70% majority ownership means nothing if the 30% minority partner gets equal voting power.

• Management authority: Without documentation, all members may have authority to bind the LLC contractually, even if you intended one person to run operations.

• Dissolution triggers: Some states allow any member to force dissolution at will, which can potentially destroy your business because one person wants out.

Your operating agreement lets you customize these rules to match your business reality.

3. Prevents Costly Disputes

Most LLC lawsuits arise from misunderstandings about roles, compensation, and ownership. Operating agreements prevent conflicts by documenting agreements while everyone is on good terms.

Critical questions answered by your operating agreement:

• Who has authority to sign contracts, hire employees, or open bank accounts?
• How are profits calculated and when are distributions made?
• What happens if the business needs more money? Are members required to contribute?
• Can members compete with the LLC or work for competitors?
• How is ownership valued if someone wants to leave?
• What happens if a member dies, gets divorced, or goes bankrupt?

These questions are easy to answer at formation but become impossibly contentious during disputes. The cost of drafting an operating agreement ($500-$2,000 with an attorney) is negligible compared to partnership litigation ($50,000-$500,000+).

4. Essential for Banking and Financing

Banks require operating agreements before opening business accounts or extending credit. They need to verify:

• Who has authority to act on the LLC’s behalf
• Ownership structure and capital contributions
• Guarantees and personal liability limitations
• Procedures for major financial decisions

Investors and lenders want to see how your LLC is governed before committing capital. Venture capitalists, angel investors, and SBA lenders all require thorough due diligence on your operating agreement.

5. Clarifies Tax Treatment

The IRS uses your operating agreement to determine how to tax your LLC:

• Single-member LLCs are taxed as disregarded entities (sole proprietorships) by default
• Multi-member LLCs are taxed as partnerships by default
• Either can elect corporate taxation (S-Corp or C-Corp)

Your operating agreement should document profit allocations, capital accounts, and tax distributions. Special allocations (distributing profits differently than ownership percentages) require detailed operating agreement provisions that demonstrate “substantial economic effect.” Otherwise, the IRS will disallow them.

Clear documentation prevents IRS challenges, audit complications, and unexpected tax bills for members.

6. Plans for Business Transitions

What happens when a member dies, becomes permanently disabled, wants to retire, gets divorced, or files bankruptcy? These aren’t hypothetical scenarios. Every long-term business faces ownership transitions.

Without planning, you risk:

• Becoming business partners with a deceased member’s heirs or surviving spouse
• A divorcing member’s ex-spouse receiving ownership in the settlement
• A bankruptcy trustee selling a member’s interest to your competitor
• Remaining members being forced to buy out a departing member at an inflated valuation

Buy-sell provisions in your operating agreement establish procedures and prices before crises force panic decisions. Many LLCs purchase life insurance on members to fund death buyouts, ensuring departing families receive cash payments rather than waiting years for installments.

Single-Member vs Multi-Member LLC Operating Agreements

The number of members dramatically affects what your operating agreement must include. Here’s how they differ:

Single-Member LLC Operating Agreements

Even as the sole owner, you need an operating agreement for liability protection, banking relationships, and succession planning.

Simplified provisions:

Single-member agreements are much shorter because you don’t need:

• Voting procedures or decision-making thresholds
• Buy-sell provisions among multiple parties
• Dispute resolution mechanisms
• Transfer restrictions to prevent unwanted partners
• Admission of new members procedures

Critical inclusions:

Despite the simplicity, single-member agreements must address:

• Capital contributions: Document your initial investment and how you’ll add capital. This creates an audit trail for IRS purposes and demonstrates separation between personal and business funds.

• Profit distributions: Specify how and when you’ll take distributions. “Whenever I feel like it” might work practically, but written procedures demonstrate business legitimacy.

• Management authority: Document that you, as the sole member, have full authority to manage the LLC and bind it contractually.

• Succession planning: This is critical and often overlooked. What happens if you die or become incapacitated? Your agreement should:

  • Name a successor member or manager to run the LLC
  • Outline how your ownership passes to heirs
  • Establish procedures for family members to sell the business if they don’t want to operate it
  • Address whether life insurance or other funds will help with estate taxes

• Dissolution: Under what circumstances will the LLC dissolve? How will assets be distributed?

Example scenario:

John forms a single-member LLC for his consulting business. His operating agreement documents that he contributed $10,000 initial capital, will take quarterly distributions based on available cash after reserves, and has sole management authority. Critically, it states that upon his death, his wife becomes successor member with the option to run the business, sell it within 180 days, or dissolve and distribute assets. This prevents his LLC from automatically dissolving upon his death (which could trigger unfavorable tax consequences and complicate estate settlement).

Multi-Member LLC Operating Agreements

When you have partners, operating agreements become essential conflict-prevention tools. They must be far more detailed than single-member versions.

Additional critical provisions:

• Ownership percentages: How is ownership divided? This doesn’t have to match capital contributions. One partner might contribute more cash while another contributes expertise, equipment, or an existing business.

• Capital contributions:

  • Who contributes what (cash, property, services, intellectual property)?
  • How are non-cash contributions valued?
  • What happens if someone doesn’t contribute their promised share?
  • Will future capital contributions be required? How are they allocated?

• Profit and loss allocations:

  • Will they be distributed proportionally to ownership or some other formula?
  • Are there preferred returns for certain members?
  • How are losses allocated for tax purposes?

• Distribution timing:

  • When are distributions made (monthly, quarterly, annually)?
  • Are they mandatory or discretionary?
  • What’s the minimum retained for operations and reserves?
  • Will tax distributions be guaranteed to cover members’ tax bills on allocated profits?

• Management structure:

  • Member-managed (all owners participate in decisions)?
  • Manager-managed (one person or hired manager runs operations)?
  • If manager-managed, who is the manager and what are their powers and limitations?

• Voting rights and thresholds:

  • Is voting proportional to ownership or one-vote-per-member?
  • What decisions require simple majority (50%+)?
  • What requires supermajority (66.67% or 75%)?
  • What requires unanimous consent?
  • Common thresholds:
    • Unanimous: Amending operating agreement, admitting new members, selling company
    • Supermajority: Large expenditures, borrowing above limits, changing business purpose
    • Majority: Hiring/firing employees, routine contracts, ordinary business decisions

• Transfer restrictions:

  • Can members sell their ownership freely?
  • Do remaining members get right of first refusal?
  • What transfers are prohibited (to competitors, creditors)?
  • What transfers are permitted (to family, trusts, wholly-owned entities)?

• Buy-sell provisions for triggering events:

  • Voluntary withdrawal: Can members leave? How much notice? What’s the buyout price?
  • Death: Heirs inherit economic interest but not management rights? Buyout timeline and price? Life insurance funding?
  • Disability: How is “disability” defined? Buyout timeline?
  • Divorce: If member’s spouse receives ownership in settlement, can remaining members buy it?
  • Bankruptcy: Remaining members’ right to purchase bankrupt member’s interest?
  • Termination for cause: Can members be forced out for misconduct? At what valuation?

• Valuation methods:

  • Fixed price (updated annually)
  • Book value (assets minus liabilities)
  • Multiple of revenue or EBITDA
  • Professional appraisal
  • Shotgun clause (one names price, other buys or sells at that price)

• Payment terms for buyouts:

  • Lump sum (rare except for small interests)
  • Installments over 3-5 years with interest
  • Down payment plus installments
  • Acceleration if LLC is sold

Example scenario:

Sarah (60% ownership, $120,000 contribution) and Marcus (40% ownership, $80,000 contribution) form an LLC. Their operating agreement specifies:

• Profits allocated 60/40 proportionally
• Sarah receives 8% annual preferred return on her $120,000 before remaining profits are split
• Distributions quarterly, minimum of 35% of allocated profits for tax obligations
• Manager-managed, with Sarah as manager for day-to-day decisions under $25,000
• Expenditures over $25,000 require both members’ approval
• Major decisions (new locations, loans over $50,000, admitting members) require unanimous consent
• Neither member can transfer ownership without the other’s written consent
• If either member dies, surviving member has 180 days to buy deceased’s interest at appraised value, funded by $500,000 life insurance policies on each member

This structure protects Sarah’s larger capital contribution while giving Marcus meaningful say in major decisions.

Member-Managed vs Manager-Managed: Which Structure Fits Your LLC?

One of the most important operating agreement decisions is how your LLC will be managed. This affects daily operations, liability exposure, and control dynamics.

Member-Managed LLCs

All owners participate in running the business, similar to a general partnership where everyone has a voice.

When to choose member-managed:

• Small number of active owners (2-4 members)
• All members work in the business daily
• Simple operations that don’t need specialized management expertise
• Strong trust and communication among members
• Professional practices (law firms, medical practices, accounting firms)

How it works:

Each member has authority to:

• Enter contracts on behalf of the LLC
• Open bank accounts and sign checks
• Hire and fire employees
• Make routine business decisions
• Represent the LLC to third parties

Your operating agreement should specify what decisions require member votes versus individual member authority.

Advantages:

• Simpler governance with less bureaucracy
• All owners have direct control over business direction
• No need to hire or compensate a separate manager
• Better for businesses where each member brings unique expertise
• More egalitarian and participatory culture

Disadvantages:

• Can slow decision-making if members disagree
• All members are exposed to liability for actions taken on LLC’s behalf
• Difficult to scale as membership grows
• Not suitable for passive investors who want returns without involvement
• Can create conflicts when members have different levels of time commitment

Operating agreement provisions for member-managed:

Management Structure: This LLC is member-managed. Each member has the authority
to participate in management and bind the LLC in contracts within the ordinary
course of business.

Major Decisions: The following require majority vote (or 2/3 supermajority):
- Selling substantially all LLC assets
- Mergers or acquisitions
- Borrowing over $50,000
- Admitting new members
- Amending this agreement
- Transactions outside ordinary business course

Manager-Managed LLCs

Members appoint one or more managers (who can be members or outside hires) to run day-to-day operations. Members retain voting rights on major decisions but don’t involve themselves in daily management.

When to choose manager-managed:

• Mix of active operators and passive investors
• Large number of members (5+)
• Some members contribute capital but don’t want operational involvement
• Real estate investments or holding companies
• Business requires professional management expertise not possessed by all members
• Members have full-time jobs and can’t participate daily

How it works:

The manager has authority for:

• Day-to-day operations and decisions
• Hiring/firing employees
• Signing contracts and opening accounts
• Routine business matters

Members retain authority for:

• Major decisions specified in operating agreement
• Removing and replacing the manager
• Approving annual budgets and strategic plans
• Distributions and capital calls

Advantages:

• Centralizes decision-making for operational efficiency
• Passive members have limited liability exposure
• Easier to recruit professional management talent
• Clear delineation between operational and strategic decisions
• Attractive to investors who want returns without management responsibility
• Simplifies governance when member count is large

Disadvantages:

• More complex governance structure
• Passive members surrender day-to-day control
• Manager may require compensation separate from ownership distributions
• Requires detailed operating agreement defining manager powers and limitations
• Potential for conflict between manager and passive members

Operating agreement provisions for manager-managed:

Management Structure: This LLC is manager-managed.

Manager: Sarah Johnson is designated as Manager with the following powers:
- Full authority for day-to-day operations
- Entering contracts under $25,000
- Hiring/firing employees
- Opening bank accounts
- Routine business decisions

Limitations on Manager Authority: Manager may NOT do the following without
2/3 member approval:
- Sell, lease, or dispose of substantially all LLC assets
- Merge or consolidate the LLC
- Borrow money exceeding $50,000
- Admit additional members
- Amend this operating agreement
- Dissolve the LLC

Manager Removal: Manager may be removed at any time by 2/3 vote of members.
Upon removal, members shall appoint a replacement manager within 30 days.

Hybrid Approach: Member-Manager

Many LLCs use a hybrid where one or more members serve as designated managers. This combines ownership and operational control while protecting passive members.

Example: In a 70/30 LLC, the 70% owner is designated as sole manager with authority for decisions under $50,000. Decisions exceeding $50,000, admitting members, amending the agreement, or selling the business require approval from both members. This gives the majority owner operational flexibility while protecting the minority owner’s investment.

Capital Contributions, Profit Allocations, and Distributions

How you structure capital contributions and profit distributions determines fairness, tax consequences, and long-term member satisfaction. Poor planning here causes more LLC conflicts than any other issue.

Types of Capital Contributions

Members can contribute various assets to the LLC:

1. Cash: The simplest and most common. Member wires or deposits money into the LLC’s bank account.

2. Property: Real estate, equipment, vehicles, inventory, or other tangible assets.

• Valuation critical: Get appraisals for valuable items to prevent disputes. If one member contributes $50,000 cash and another contributes equipment they claim is worth $50,000, an independent appraisal prevents resentment if the equipment is actually worth $30,000.
• Tax implications: Contributing property may trigger taxable gains if the property has appreciated since acquisition.
• Title transfer: Property contributions require proper legal transfer (deeds for real estate, bills of sale for equipment).

3. Services: A member’s time, expertise, or labor.

• IRS scrutiny: The IRS may treat services as taxable compensation to the contributing member.
• Valuation challenges: How do you value expertise or future work commitments?
• Best practice: Many LLCs avoid service contributions at formation, instead compensating members for services via guaranteed payments or W-2 wages.

4. Intellectual Property: Patents, trademarks, copyrights, trade secrets, or proprietary processes.

• Transfer documentation required: IP contributions require assignment agreements transferring ownership to the LLC.
• Valuation complexity: Consider professional IP valuation for significant contributions.
• Ongoing development: Clarify whether future improvements belong to the member or the LLC.

5. Existing Business: One member contributes an ongoing operation with customers, contracts, and goodwill.

• Due diligence essential: Verify assets, liabilities, contracts, and customer relationships.
• Assumption of liabilities: Document which business debts the LLC assumes versus which remain with the contributing member.

Capital Contribution Best Practices

Document everything in detail:

Your operating agreement should include a capital contributions schedule:

Initial Capital Contributions:
- Member A: $75,000 cash (contributed January 15, 2024)
- Member B: $25,000 cash + 2019 Ford F-150 (appraised value $20,000)
- Total Initial Capital: $120,000

Member A Capital Account: $75,000 (62.5%)
Member B Capital Account: $45,000 (37.5%)

Value contributions fairly:

Overvaluing non-cash contributions creates tax problems and member resentment. If one member contributes “sweat equity” worth $50,000 but it’s actually worth $20,000, allocations will be unfair from day one.

Address unequal contributions upfront:

Ownership percentage doesn’t have to match contribution percentage. You might give 50/50 ownership to members who contributed 70/30 if the smaller contributor brings critical operational expertise. Document the reasoning:

Member A contributed $70,000 (70% of capital) and Member B contributed $30,000
(30% of capital). Members agree to 50/50 ownership in recognition of Member B's
industry expertise and existing customer relationships valued at $40,000.

Plan for additional capital needs:

What happens if the business needs more money in year two? Address this before it’s needed:

• Are members required to contribute additional capital proportionally?
• What happens if a member can’t or won’t contribute?
• Can the LLC admit new members instead?
• If some members contribute and others don’t, how does ownership change?

Example provision:

Additional Capital Contributions: If the LLC requires additional capital,
members may vote to call for contributions proportional to ownership. Members
have 30 days to contribute their share. If a member fails to contribute:

(a) Their ownership percentage is diluted proportionally to contributing members
(b) Contributing members may charge 8% annual interest on advanced funds
(c) The LLC may admit new members to provide needed capital

Profit and Loss Allocation

How profits and losses are divided for accounting and tax purposes. This is separate from cash distribution timing.

Common allocation methods:

1. Proportional to ownership (most common):

A 60% owner gets 60% of profits and bears 60% of losses. Simple and aligns economic interest with ownership stake.

2. Equal distribution:

Each member gets an equal share regardless of ownership percentage. Rare except among equal partners in professional practices.

3. Special allocations:

Custom arrangements like:

• “Member A receives first $50,000 of profit annually as return of capital, then remaining profit is split 50/50”
• “Losses allocated 100% to Member A until their capital account reaches zero, then proportionally”
• “Member B receives 8% annual preferred return, then remaining profits split proportionally”

IRS scrutiny: Special allocations must have “substantial economic effect,” meaning they must affect members’ economic positions, not just manipulate tax benefits. Work with a CPA to ensure compliance.

4. Preferred returns:

Common in real estate LLCs and investment structures. Certain members (often investors) receive guaranteed minimum returns before other members receive distributions.

Example: Member A (investor) contributed $200,000 and receives 8% annual preferred return ($16,000). After the preferred return, remaining profits are split 50/50 between Member A and Member B (operator).

Distribution Timing and Amounts

Profit allocation for taxes is separate from cash distribution decisions. This confuses many LLC members.

Key distinction:

• Allocation: Determines each member’s share of profits/losses for tax purposes. Members pay taxes on allocated profits whether or not cash is distributed.
• Distribution: Actual cash payments to members.

Critical questions your operating agreement must answer:

When are distributions made?

• Monthly (rare, creates cash flow challenges)
• Quarterly (common for profitable LLCs)
• Annually (common for real estate and growth-focused businesses)
• Discretionary (as determined by manager or member vote)

Are distributions mandatory or discretionary?

Many operating agreements leave distributions to manager or member discretion, allowing the LLC to retain earnings for:

• Paying down debt
• Funding growth and expansion
• Building cash reserves
• Capital expenditures

Tax distributions (critical for multi-member LLCs):

LLCs are pass-through entities, so members pay taxes on their allocated share of profits even if no cash is distributed. This creates “phantom income” tax bills.

Best practice: Require minimum annual “tax distributions” to cover members’ tax liability.

Example provision:

Tax Distributions: The LLC shall distribute to each member, no later than
March 15 of each year, an amount equal to that member's allocated share of
prior year's taxable income multiplied by 40% (estimated combined federal
and state tax rate). This ensures members have cash to pay taxes on LLC income.

Additional discretionary distributions may be made as determined by the Manager
or majority vote of members.

Can distributions differ from ownership percentages?

Generally no, as this creates tax complications. Distributions should follow profit allocations to maintain proper capital account balances.

Real-World Example: Complex Capital Structure

Scenario: Tech startup LLC with three members.

Member A (Founder):

• Contributed: $50,000 cash + proprietary software (valued at $100,000)
• Ownership: 50%
• Role: CEO, full-time

Member B (Investor):

• Contributed: $150,000 cash
• Ownership: 30%
• Role: Passive investor
• Preferred return: 10% annually on $150,000 ($15,000/year)

Member C (Operator):

• Contributed: $50,000 cash
• Ownership: 20%
• Role: COO, full-time

Operating agreement provisions:

Total Capital Contributions: $350,000

Profit Allocation:
1. Member B receives 10% preferred return ($15,000 annually) first
2. Remaining profits allocated: 50% to A, 30% to B, 20% to C

Loss Allocation: Proportional to ownership (50/30/20)

Distributions:
- Quarterly tax distributions (40% of allocated profits)
- Member B's preferred return paid quarterly
- Additional distributions at Manager's discretion, proportional to ownership

Additional Capital Calls:
- If needed, proportional to ownership
- If member doesn't contribute within 30 days, ownership dilutes proportionally

This structure compensates Member B’s larger capital contribution with preferred returns while maintaining Member A’s control through majority ownership.

Buy-Sell Provisions and Transfer Restrictions: Protecting Your LLC from Unwanted Partners

The most overlooked and most critical part of any multi-member operating agreement: what happens when a member wants to leave, dies, gets divorced, or goes bankrupt.

Without proper provisions, you could wake up as business partners with a deceased member’s heir, a divorcing member’s ex-spouse, your competitor, or a bankruptcy trustee. Buy-sell provisions and transfer restrictions prevent these nightmares.

Why Transfer Restrictions Matter

Limited liability companies are built on trust and chosen relationships. Without restrictions, a member could sell their ownership to anyone, turning your carefully selected partnership into an unwanted arrangement.

Real scenario: You and your business partner build a successful software company over five years. Without consulting you, your partner sells their 40% interest to a private equity firm that immediately demands board seats, operational changes, and dividend payouts that drain growth capital. Your partnership is destroyed, and you have no legal recourse because your operating agreement didn’t restrict transfers.

Essential protection: Transfer restrictions give existing members control over who can become an owner.

Common Transfer Restriction Types

1. Consent Requirement

The simplest approach: members can’t transfer ownership without written approval from other members.

Consent thresholds:

• Unanimous: Every member must approve. Maximum protection but can deadlock decisions.
• Supermajority (2/3 or 75%): Balances protection with practicality for larger LLCs.
• Majority (50%+): Minimum protection, rarely recommended.

Example provision:

Transfer Restrictions: No member may sell, assign, pledge, or otherwise transfer
their membership interest without the prior written consent of members holding
at least 75% of ownership interests (excluding the transferring member). Any
attempted transfer without required consent is void.

2. Right of First Refusal (ROFR)

If a member receives an outside offer, they must first offer their interest to existing members on identical terms.

How it works:

1. Member B receives offer from outside investor: $200,000 for B’s 30% interest
2. B must offer this deal to existing members first
3. Existing members have 30-45 days to accept on same terms
4. If they decline, B can sell to the outsider
5. If they accept, they buy B out for $200,000

Example provision:

Right of First Refusal: Before selling to a third party, a member must deliver
written notice to all other members describing the proposed sale terms (price,
payment terms, buyer identity). Other members have 30 days to purchase the
interest on identical terms. If multiple members wish to purchase, they purchase
proportionally to their existing ownership percentages.

3. Right of First Offer (ROFO)

Before seeking outside buyers, the member must offer their interest to existing members at a price they set.

Difference from ROFR: The selling member sets the price before shopping to outsiders.

How it works:

1. Member wants to sell
2. Makes offer to existing members: “I’ll sell my 25% for $150,000”
3. Existing members have 30 days to accept
4. If they decline, member can market to outsiders but must get at least $150,000
5. If they get a higher outside offer, they must give existing members another chance at the higher price

4. Prohibited Transfer Restrictions

Some operating agreements categorically prohibit transfers to certain parties:

Prohibited Transfers: Members may not transfer interests to:
- Direct competitors of the LLC
- Creditors or bankruptcy trustees
- Any person or entity not approved by 2/3 member vote

Permitted Transfers: Notwithstanding the above, members may transfer to:
- Immediate family members (spouse, children, parents, siblings)
- Trusts for the benefit of the member or their family
- Entities wholly owned by the member
provided the transferee agrees in writing to be bound by this agreement.

Buy-Sell Provisions: Planning for the Inevitable

Buy-sell provisions specify what happens when specific triggering events occur. These are mandatory for multi-member LLCs.

Common triggering events:

1. Voluntary Withdrawal

Member wants to leave the business.

Operating agreement provisions:

• Notice requirement (typically 60-90 days)
• Buyout valuation method
• Payment terms
• Restrictions during notice period (can’t solicit customers, steal employees)
• Whether member can force buyout or needs member approval

Example:

Voluntary Withdrawal: A member may withdraw upon 90 days' written notice to
all other members. Upon withdrawal:

(a) Remaining members have the option (but not obligation) to purchase the
    withdrawing member's interest at fair market value as determined by
    independent business appraisal
(b) Purchase price paid in installments: 25% down, remaining 75% over 36 months
    at 6% annual interest
(c) If remaining members decline to purchase, the withdrawing member may offer
    their interest to third parties subject to Right of First Refusal
(d) Withdrawing member remains bound by non-compete and confidentiality
    obligations for 24 months

2. Death

Member dies. Without planning, heirs inherit the membership interest.

Problems this creates:

• Remaining members are suddenly in business with the deceased’s family
• Heirs may have no interest in or aptitude for the business
• Heirs may want immediate cash payouts, draining business capital
• Remaining members may lack liquidity to buy out the interest

Solution: Operating agreement gives remaining members option to purchase the deceased member’s interest, with life insurance providing funding.

Example provision:

Death of a Member: Upon a member's death:

(a) The deceased member's heirs inherit economic rights (distributions) but NOT
    management or voting rights
(b) Remaining members have 180 days to purchase the deceased member's interest
    at fair market value (determined by appraisal within 60 days of death)
(c) Purchase price paid from life insurance proceeds (LLC maintains $500,000
    policy on each member) plus installment payments if needed
(d) If remaining members do not exercise purchase option within 180 days,
    heirs may become full members upon 2/3 vote approval

Life insurance funding: Each member’s life is insured for their buyout value. LLC owns policies and is beneficiary. Upon death, insurance provides cash for buyout, allowing clean transition without draining business capital or forcing installment payments to grieving families.

3. Disability

Member becomes permanently unable to perform their duties.

Critical definition: “Disability” must be clearly defined to prevent disputes.

Common definition:

Disability: A member is considered disabled if they are unable to perform their
essential duties for the LLC for six (6) consecutive months due to physical or
mental incapacity, as certified by two independent physicians.

Example provision:

Disability: If a member becomes disabled:

(a) Disabled member continues receiving their share of distributions for
    12 months while seeking recovery
(b) After 12 months of continued disability, remaining members have the option
    to purchase the disabled member's interest at 80% of fair market value
(c) Purchase price paid over 48 months with 5% annual interest
(d) Disabled member may purchase disability insurance to fund personal needs
    during buyout period

4. Divorce

Member’s spouse is awarded part of membership interest in divorce settlement.

The nightmare scenario: Your business partner gets divorced. Their ex-spouse receives 50% of your partner’s LLC ownership in the settlement. You’re now in business with your partner’s ex, who may be hostile, unqualified, or seeking to liquidate the business for cash.

Example provision:

Divorce: In the event of a member's divorce:

(a) The member's spouse receives only economic rights (distributions), NOT
    management or voting rights
(b) Remaining members have 120 days to purchase the ex-spouse's interest at
    fair market value
(c) If remaining members decline, the divorced member must purchase the
    ex-spouse's interest within 180 days
(d) If neither purchase occurs, the LLC may be dissolved at the option of
    members holding 2/3 ownership

Spousal consent: In community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, Wisconsin), consider requiring spouses to sign the operating agreement acknowledging transfer restrictions.

5. Bankruptcy

Member files bankruptcy. Bankruptcy trustee may try to sell the membership interest to pay creditors.

Example provision:

Bankruptcy: If a member files bankruptcy or has an involuntary bankruptcy
petition filed against them:

(a) Remaining members have 60 days to purchase the bankrupt member's interest
    at 60% of book value (discounted for forced sale)
(b) Purchase price paid in cash within 60 days
(c) Bankrupt member's voting and management rights are immediately suspended
    until bankruptcy is resolved or interest is purchased

6. Termination for Cause

Member commits fraud, embezzlement, or serious breach of agreement.

Example provision:

Termination for Cause: A member may be expelled for:
- Fraud, embezzlement, or theft from the LLC
- Criminal conviction related to the business
- Material breach of this agreement not cured within 30 days
- Competing with the LLC in violation of non-compete obligations

Upon 2/3 vote for expulsion:
(a) Expelled member's voting and management rights immediately terminate
(b) Remaining members purchase expelled member's interest at 50% of fair
    market value (penalty for misconduct)
(c) Payment within 90 days, in cash
(d) Expelled member remains liable for damages caused to the LLC

Valuation Methods for Buyouts

How do you determine buyout price? This is often the most contentious issue. Common methods:

1. Fixed Price

Set a specific dollar amount per ownership percentage point, updated annually.

Example: $5,000 per 1% ownership. A 30% member is bought out for $150,000.

Advantages: Simple and predictable. Disadvantages: Requires annual updates or becomes outdated quickly.

2. Book Value

Based on LLC’s balance sheet (assets minus liabilities).

Advantages: Easy to calculate from financial statements. Disadvantages: May undervalue profitable businesses with significant intangible assets (customer relationships, brand value, proprietary processes).

3. Multiple of Revenue or EBITDA

Common in service businesses and operating companies.

Examples:

• 1× annual revenue
• 2.5× annual revenue
• 5× EBITDA (Earnings Before Interest, Taxes, Depreciation, Amortization)

Advantages: Reflects business profitability and growth. Disadvantages: Multiples vary by industry and market conditions. Must specify which year’s revenue/EBITDA.

Example provision:

Valuation: Membership interests shall be valued at 5× the LLC's trailing
12-month EBITDA as of the triggering event date. EBITDA shall be calculated
from the LLC's audited financial statements prepared in accordance with GAAP.

4. Professional Appraisal

Hire a certified business appraiser to determine fair market value.

Advantages: Most accurate and defensible. Disadvantages: Expensive ($3,000-$10,000+) and time-consuming (30-60 days).

Best practice: Use appraisal for large buyouts (interests over 20% or values exceeding $100,000) but simpler methods for smaller transactions.

Example provision:

Valuation: For interests exceeding 20% ownership, fair market value shall be
determined by an independent business appraiser certified by the American
Society of Appraisers. Appraiser shall be jointly selected by buyer and seller.
If parties cannot agree, each selects an appraiser and those two appraisers
select a third. Appraisal completed within 60 days of triggering event.

5. Shotgun Clause

One member names a price, the other can either buy at that price or sell at that price.

How it works:

1. Member A offers: “I’ll buy your 40% for $200,000 or sell my 60% to you for $300,000”
2. Member B must choose: buy A’s 60% for $300,000 or sell their 40% to A for $200,000

Advantages: Forces fair pricing because Member A can’t lowball when B can flip it. Disadvantages: Only works with two members. Requires both to have buyout liquidity.

Payment Terms for Buyouts

Few LLCs can afford large lump-sum buyouts. Your operating agreement should specify payment terms:

Common structures:

Payment Terms:
- 20% down payment within 30 days of closing
- Remaining 80% paid in equal quarterly installments over 4 years
- 6% annual interest on unpaid balance
- Payments secured by security interest in the purchased membership interest
- Acceleration upon LLC sale or if buyer defaults on payments

Security interest: Selling member retains a security interest (lien) in the purchased ownership until paid in full. If buyers default, seller can reclaim the ownership.

Acceleration clauses: Outstanding balance becomes immediately due if:

• LLC is sold to a third party
• LLC’s EBITDA increases by 50%+
• Buyer receives distributions exceeding $X amount

These prevent buyers from slow-paying while reaping benefits of the purchased ownership.

State-Specific Requirements: Does Your State Require an Operating Agreement?

LLC laws vary significantly by state. Understanding your state’s requirements ensures your operating agreement is enforceable and compliant.

States That Require Operating Agreements

California: Technically requires LLCs to “have an operating agreement” but doesn’t specify written versus oral, and there’s no penalty for noncompliance. Practically, always put it in writing.

Delaware: Doesn’t require an operating agreement, but Delaware LLC statute explicitly recognizes and enforces oral operating agreements. Still, written is always better for enforceability.

Maine, Missouri, New York: Statutes require operating agreements but don’t specify they must be written. Again, always document in writing.

Bottom line: Even states that don’t explicitly require written operating agreements universally expect them in practice. No competent attorney would advise operating without one.

State Default Rules (What Applies Without an Operating Agreement)

If you don’t create custom rules, your state’s default LLC statute governs. Common defaults that often surprise LLC owners:

Profit sharing:

• Many states default to equal profit sharing regardless of ownership percentage or capital contribution
• Example: In some states, if Member A contributed $90,000 (90%) and Member B contributed $10,000 (10%), profits may still be split 50/50 by default
• Solution: Operating agreement overrides this with custom allocations

Management structure:

• Most states default to member-managed unless you specify manager-managed in Articles of Organization or operating agreement
• Problem: All members may have authority to bind the LLC, even passive investors you didn’t intend to have signing authority

Voting rights:

• Some states default to one vote per member (not weighted by ownership)
• Example: Your 70% ownership gives you no more voting power than the 30% minority member
• Solution: Operating agreement specifies voting proportional to ownership

Transfer of interests:

• Many states allow members to freely transfer economic interests (right to distributions) but not management rights
• Problem: You end up paying distributions to people you never chose as partners
• Solution: Operating agreement restricts all transfers

Dissolution:

• Some states allow any member to force dissolution at will
• Problem: One disgruntled member can destroy the entire business
• Solution: Operating agreement requires supermajority or unanimous consent to dissolve

California-Specific Considerations

California has unique LLC rules that affect operating agreements:

Annual franchise tax: Minimum $800 annual tax, plus gross receipts fee for LLCs earning over $250,000. Can’t be avoided, but operating agreement should address who pays (LLC vs members).

Securities compliance: Admitting new members or offering LLC interests may require securities law compliance. Operating agreement should include securities law representations.

Community property: Married members’ interests may be community property. Consider requiring spousal consent for major decisions.

Employee protections: California limits non-compete enforceability. Operating agreement non-competes may be unenforceable for employees who are also members.

Delaware-Specific Considerations

Delaware is the most popular state for LLC formation due to business-friendly laws:

Maximum flexibility: Delaware LLC Act is extremely permissive, allowing operating agreements to customize almost everything.

Extensive case law: Decades of business litigation provide predictability about how courts will interpret operating agreement provisions.

Court of Chancery: Specialized business court with expert judges who understand complex LLC structures.

Strong veil protection: Delaware courts strongly protect LLC separate legal existence, making veil-piercing difficult.

Non-resident friendly: Members and managers don’t need to be Delaware residents.

Foreign registration required: If your LLC primarily operates in another state, you must register as a “foreign LLC” there and comply with both states’ laws. Delaware formation doesn’t eliminate home state requirements.

Series LLC States

Twelve states and jurisdictions allow “Series LLCs,” which consist of a master LLC with separate sub-series that have their own members, assets, and liabilities:

• Delaware, Illinois, Iowa, Nevada, Oklahoma, Tennessee, Texas, Utah, Wisconsin, Kansas, North Dakota, Puerto Rico, District of Columbia

Use cases:

• Real estate investors segregating different properties
• Businesses separating different product lines or ventures
• Holding companies isolating liability for different assets

Operating agreement requirements:

Series LLCs require complex operating agreements addressing both the master LLC and each series. Each series needs its own capital accounts, allocations, and management structure. Consult an attorney experienced in series LLCs because they’re more complex than standard LLCs.

Community Property States

Nine states have community property laws affecting LLC ownership:

• Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, Wisconsin (Alaska if elected)

Impact on operating agreements:

Spousal consent: Consider requiring married members to obtain spousal consent before:

• Signing the operating agreement
• Transferring ownership
• Voting on major decisions
• Admitting new members

Divorce considerations: Community property states presume assets acquired during marriage are owned 50/50 by both spouses. Your operating agreement’s divorce provisions must account for this.

Example provision:

Community Property Acknowledgment: For members residing in community property
states, the member's spouse must sign this agreement acknowledging and consenting
to:
(a) The member's ownership and investment in the LLC
(b) Transfer restrictions and buy-sell provisions
(c) That the membership interest is subject to this agreement's terms

Professional LLCs (PLLCs)

If your LLC provides professional services (law, medicine, accounting, architecture, engineering), most states require a Professional LLC with special restrictions:

Requirements:

• All members must be licensed in the profession
• PLLC doesn’t shield members from personal malpractice liability (only from general business debts)
• May require professional liability insurance
• Special naming requirements (must include “PLLC” or “Professional LLC”)
• Some states prohibit multi-disciplinary PLLCs (e.g., lawyers and accountants together)

Operating agreement considerations:

• Address what happens if a member loses their professional license (forced buyout)
• Malpractice insurance requirements
• Professional responsibility and ethical obligations
• Limitations on delegation to unlicensed staff

When to Consult a State-Specific Attorney

While general templates work for simple LLCs, consult an attorney licensed in your state for:

• Multi-state operations (need to comply with all relevant state laws)
• Complex ownership structures (preferred returns, profits interests, vesting schedules)
• Professional LLCs
• Members in different states or countries
• Significant real estate holdings
• Raising money from investors or venture capital
• Estate planning concerns (trusts, family succession)
• High-liability businesses (construction, healthcare, financial services)

Cost: Attorney review typically costs $500-$2,000. Custom drafting for complex LLCs costs $2,000 to $10,000 or more. This is cheap insurance compared to the cost of fixing problems later.

Common Mistakes That Make Operating Agreements Unenforceable

Even with an operating agreement, certain mistakes can render it worthless in court. Avoid these critical errors:

1. No Consideration (Contract Basics 101)

The mistake: Asking someone to sign an operating agreement after they’ve already received confidential information, started working, or been operating as a member.

Why it fails: Contracts require “consideration,” which means something of value exchanged by both parties. A promise to follow rules you’re already following isn’t consideration.

Real case: A member was added to an LLC and worked for six months before being asked to sign an operating agreement with non-compete provisions. Court refused to enforce the non-compete because the member received nothing new in exchange for signing. They were already a member.

Fix: Get operating agreements signed at formation, before anyone contributes capital or begins work. If you must add provisions later, offer something new (additional ownership, guaranteed distributions, compensation increase).

2. Overly Broad or Unreasonable Restrictions

The mistake: “Member will not disclose any information learned during the relationship, directly or indirectly, to any person or entity, for any purpose, forever.”

Why it fails: Courts strike down provisions that:

• Restrict public information or general industry knowledge
• Prevent members from using skills acquired on the job
• Impose unreasonable time limits (10+ years for ordinary business information)
• Cover impossibly broad geographic areas
• Prohibit all future work in the industry (that’s non-compete, and enforceability varies by state)

Fix: Be specific and reasonable. Define confidential information precisely, limit non-competes to reasonable time and geography, and exclude public information and general skills.

Example of enforceable provision:

Confidential Information: Means (a) customer lists and contact information,
(b) pricing strategies and cost structures, (c) proprietary formulas and
processes, (d) financial projections and strategic plans, (e) information
marked "Confidential" at time of disclosure.

Confidential Information does NOT include: (i) publicly available information,
(ii) information known to member before joining LLC, (iii) information
independently developed, (iv) general industry knowledge and skills.

Non-Compete: For 24 months following departure, member will not directly
compete with the LLC within 50 miles of LLC's principal office by operating
a substantially similar business serving the LLC's customer base.

3. Ambiguous or Contradictory Provisions

The mistake: Operating agreement says “major decisions require unanimous consent” but doesn’t define “major decisions.” Or it defines them differently in different sections.

Why it fails: Courts can’t enforce vague terms. If members dispute whether a decision is “major,” there’s no objective standard to apply.

Real scenario: Operating agreement required “unanimous consent for significant expenditures.” Members disagreed on whether a $30,000 equipment purchase was “significant.” Litigation ensued.

Fix: Define key terms precisely and use them consistently throughout the document.

Example:

Major Decisions: The following require 2/3 supermajority vote:
(a) Expenditures exceeding $25,000 (single transaction or related transactions)
(b) Borrowing exceeding $50,000
(c) Hiring employees with annual compensation exceeding $75,000
(d) Entering contracts with terms exceeding 12 months
(e) Selling, leasing, or encumbering LLC assets worth more than $50,000
(f) Admitting new members or removing existing members
(g) Amending this operating agreement
(h) Merging, consolidating, or dissolving the LLC

4. Missing “No License” or “No Partnership” Clauses

The mistake: Omitting language clarifying that the operating agreement doesn’t grant rights beyond what’s explicitly stated.

Why it matters:

• IP risk: Member claims that receiving confidential information implies license to use intellectual property for personal projects
• Partnership claims: Vendor or contractor claims they’re actually a member based on informal discussions

Fix: Include protective clauses.

Example:

No License or Rights: This Agreement does not grant any member any license,
express or implied, to any intellectual property, trade secrets, or proprietary
information except the limited right to use such information solely for LLC
business purposes.

No Third-Party Rights: This Agreement is solely among the members and does not
create any rights for third parties (contractors, vendors, employees) unless
explicitly stated.

No Partnership: Members are not partners in a general partnership. This LLC is
governed by [State] LLC statutes, not partnership law.

5. Requiring Impossible or Impractical Compliance

The mistake: “Member will not allow any employee to view confidential information without individual NDAs signed directly with all members.”

Why it fails: Impractical requirements that make normal business operations impossible won’t be enforced.

Real scenario: Operating agreement required unanimous member approval for all contracts. One member traveled internationally for six months, which paralyzed business operations.

Fix: Make requirements practical and include workarounds for unusual situations.

Example:

Employee Confidentiality: Members will limit access to LLC confidential
information to employees and contractors who have signed confidentiality
agreements with the LLC containing protections at least as strong as those
in this Agreement.

Contract Authority: Contracts under $25,000 may be signed by any Manager or
by members holding 25%+ ownership. Contracts exceeding $25,000 require
written approval from members holding 50%+ ownership, which may be obtained
via email confirmation if in-person signatures are impractical.

6. No Jurisdiction or Dispute Resolution Clause

The mistake: Forgetting to specify where disputes will be resolved.

The problem: Members in different states create jurisdictional questions. Where do you sue for breach? Which state’s law applies? Do you litigate in a member’s home state or where the LLC is formed?

Fix: Specify governing law and jurisdiction clearly.

Example:

Governing Law: This Agreement is governed by the laws of the State of Delaware,
without regard to its conflict of law provisions.

Jurisdiction: Any disputes arising from this Agreement shall be resolved
exclusively in the state or federal courts located in Wilmington, Delaware.
Members consent to personal jurisdiction in Delaware and waive any objection
based on inconvenient forum.

Alternative: Arbitration: Any disputes shall be resolved by binding arbitration
under AAA Commercial Arbitration Rules, conducted in [City, State]. Arbitrator's
decision is final and binding. Prevailing party recovers reasonable attorneys'
fees.

Arbitration advantages:

• Faster than litigation (typically 6-12 months vs 2-4 years)
• Private (no public court records)
• Expert arbitrators who understand business
• Generally less expensive
• Enforceable across states

Arbitration disadvantages:

• Limited appeal rights
• Can’t compel third-party discovery as easily
• Arbitrator fees can be expensive ($5,000 to $20,000 or more)

7. Inconsistency Between Articles of Organization and Operating Agreement

The mistake: Articles of Organization filed with the state say “manager-managed” but operating agreement says “member-managed.”

Why it matters: Courts typically give priority to the filed Articles of Organization (public record) over the operating agreement (private contract) when they conflict.

Fix: Ensure Articles of Organization and operating agreement align on:

• Management structure (member-managed vs manager-managed)
• Manager names (if manager-managed)
• Registered agent
• Principal office address

If you need to change management structure, file an amendment to Articles of Organization and update operating agreement simultaneously.

8. Failure to Follow Your Own Agreement

The biggest mistake of all: Creating a detailed operating agreement and then ignoring it.

Examples of non-compliance:

• Agreement requires annual member meetings, yet haven’t met in three years
• Agreement says distributions require member vote, yet manager makes distributions without asking
• Agreement prohibits expenditures over $25,000 without approval, yet members routinely exceed without votes
• Agreement requires written consents for major decisions, yet everything done via verbal discussions

Why this destroys your agreement:

• Courts may refuse to enforce provisions you don’t follow (“waiver by conduct”)
• Demonstrates your LLC lacks formal governance (supports veil-piercing)
• Creates member disputes about which rules apply (written agreement or actual practice?)
• Weakens liability protection

Fix: Actually follow your operating agreement. If provisions are impractical:

1. Amend the agreement to match reality
2. Document decisions via written consents (email confirmations work)
3. Hold annual meetings (even brief ones) and keep minutes
4. Review agreement annually and update as needed

Pro tip: Set calendar reminders for required actions (annual meetings, capital account reconciliations, distribution approvals) to ensure compliance.

Frequently Asked Questions

Is an LLC operating agreement legally required?

Only California, Delaware, Maine, Missouri, and New York legally require written operating agreements. However, ALL LLCs should have one to protect limited liability status and prevent disputes. Without an operating agreement, your state’s default LLC laws apply, which often conflict with what members actually want.

Can I write my own LLC operating agreement?

Yes, you can draft your own operating agreement using templates or generators. However, complex multi-member LLCs or those with unusual ownership structures should have an attorney review the document. For simple single-member LLCs or standard 50/50 partnerships, a well-designed template or generator provides a solid foundation.

What is the difference between member-managed and manager-managed LLCs?

Member-managed means all owners participate in day-to-day decisions and can bind the LLC contractually. Manager-managed means one or more designated managers (who can be members or outside hires) run operations while other members act as passive investors. Choose member-managed for small, active partnerships and manager-managed when you have passive investors or need centralized decision-making.

How long should an LLC operating agreement be?

Single-member operating agreements are typically 5-10 pages. Multi-member agreements range from 15-30 pages depending on complexity. Length matters less than completeness. Your agreement must address capital contributions, profit allocations, management structure, voting rights, buy-sell provisions, and dispute resolution regardless of page count.

What happens if you don’t have an operating agreement?

Without an operating agreement, your state’s default LLC statutes control everything. This often produces unfair results like equal profit sharing regardless of capital contributions, any member being able to force dissolution, and all members having authority to bind the LLC. Courts are also more likely to pierce the corporate veil and expose your personal assets when you lack formal governance documents.

Ready to Create Your LLC Operating Agreement?

Use our Free LLC Operating Agreement Generator to create a complete, customized operating agreement in minutes. Our step-by-step wizard guides you through:

• Single-member vs multi-member selection
• LLC information and formation details
• Member information and ownership percentages
• Management structure (member-managed or manager-managed)
• Capital contributions and profit allocations
• Operating details (fiscal year, voting thresholds)
• Preview and download as PDF

Important: While our generator creates a solid foundation with all essential provisions, we strongly recommend having an attorney licensed in your state review the agreement before signing, especially for:

• Multi-member LLCs with complex ownership
• Manager-managed structures
• Unequal ownership or special profit allocations
• Real estate holdings or high-value assets
• Professional LLCs
• Estate planning considerations

Next steps after creating your agreement:

1. Have all members review and sign it
2. Provide copies to your attorney, accountant, and banker
3. Store the original in a secure location
4. Review and update annually
5. Actually follow the procedures you documented
6. Consider life insurance to fund death buyouts
7. Consult a CPA about tax distributions and allocations

Your operating agreement is the most important document for protecting your LLC, your members, and your business. Take the time to create a complete, customized agreement that reflects your actual business structure and relationships. The hour you invest now can prevent years of costly litigation and partnership conflicts later.