Contents

Operating AgreementEdit

An operating agreement is a private contract that governs how a business organized as an Limited liability company or a similar entity will be run. It sits alongside the entity’s formal filings with the state and the relevant corporate or tax rules, but it is where the substantive governance and day-to-day expectations are written. For many small businesses and startups, the operating agreement acts as a kind of constitution—laying out who contributes what, who makes decisions, how profits and losses are allocated, and how disputes are resolved. By setting these terms in advance, owners reduce the chance of later fights and align incentives around practical, measurable outcomes.

From a practical standpoint, the operating agreement addresses questions that the state statutes may not answer to the satisfaction of the members. It clarifies the scope of authority for managers or members, codifies processes for voting and consent, and provides mechanisms for bringing in new members, buying out existing ones, or winding down the business. It also helps define ownership protections, tax treatment, and the allocation of capital accounts and distributions. In this way, the document facilitates private ordering—the ability of people to structure a business to fit their specific risk tolerance, capital structure, and long-term goals.

Core elements of an operating agreement

  • Formation and purpose
  • Capital contributions and ownership
    • Specifies who contributes capital, the nature of those contributions, and how ownership interests are determined and tracked, including any preferred or special classes of interests. See Capital accounts and Membership interests for related concepts.
  • Profits, losses, and distributions
    • Allocates profits and losses among members and sets rules for when and how distributions will be made, subject to tax considerations and cash needs of the business.
  • Management and voting
    • Describes whether the entity is member-managed or manager-managed, who has authority to bind the company, and what voting thresholds apply to different actions. See Manager-managed and Member-managed structures for related ideas.
  • Transfer restrictions and admission of new members
    • Controls sales or transfers of interests, right of first refusal, and conditions under which new members can join or existing members can exit.
  • Fiduciary duties and conduct
    • Establishes the standards of conduct for those running the business, including loyalty and care, and permits carve-outs or limitations consistent with applicable law. See Fiduciary duty for context on duties landlords and managers owe to the entity and to members.
  • Deadlock and dispute resolution
    • Provides mechanisms to resolve stalemates when there is no clear majority, such as mediation, buy-sell provisions, or rotating decision rights.
  • Buy-sell provisions and exit
    • Sets out price mechanisms, funding methods, and timing for member buyouts or forced exits to keep the enterprise functional.
  • Tax treatment and allocations
    • Addresses how the entity’s tax status (often a pass-through for an LLC) affects allocations to members and the handling of tax distributions.
  • Amendments and dissolution
    • Establishes how the operating agreement itself can be amended and the process for dissolution, winding up, and termination of the business.

Variations in structure and governance

  • Member-managed vs. manager-managed
    • In a member-managed structure, all or most members participate in day-to-day decisions. In a manager-managed structure, designated managers (who may be members or outsiders) handle operations, while members retain ownership rights. The operating agreement is the primary document that allocates authority and sets limitations on what managers can do without consent. See Manager-managed and Member-managed.
  • Class and preference structures
    • Some entities create classes of membership with different allocation and voting rights, which the operating agreement formalizes. This is particularly common in growth-stage businesses or in partnerships with outside investors. See Class (business) and Preferred stock for related concepts.
  • Protection and risk controls
    • The agreement may include indemnification provisions, insurance requirements, and standards for financial reporting and internal controls, all aimed at reducing risk and aligning incentives with long-run value creation.

Enforceability and legal context

  • Interaction with state law
    • While the operating agreement governs private conduct among members, it remains subject to state statutes governing LLCs and contracts. In many places, the agreement can modify or expand upon default fiduciary duties and voting rules, so long as the changes are consistent with law and public policy. See Revised Uniform Limited Liability Company Act and State LLC statutes for the broader framework.
  • Fiduciary duties and carve-outs
    • Managers and members may face duties of loyalty and care, but the operating agreement can shape, narrow, or tailor those duties through explicit provisions. This can improve flexibility but may raise concerns among those who fear that safeguards against self-dealing or negligent management are weakened.
  • Minority protections and remedies
    • Critics worry that tailored private agreements can leave minority members without effective recourse if the majority acts to advance its own interests. In practice, these concerns are often mitigated by explicit protections, third-party dispute resolution, and, where available, court-reviewed oppression remedies. See Oppression remedy for related ideas.

Controversies and debates

  • Private ordering versus inclusive governance
    • Proponents argue that private governance through an operating agreement enables fast, tailored decisions that reflect the specific risks and opportunities of a venture. This efficiency is attractive in dynamic markets where speed and specificity matter. Critics contend that too much reliance on private arrangements can lock in arrangements that favor insiders and narrow the range of perspectives in decision-making.
  • Minority rights and exit options
    • The right-of-center emphasis on property rights and contractual freedom supports clear exit options and predictable remedies for disagreements. Critics, however, worry that without robust minority protections, a majority can dilute or sideline minority interests. The defense is that well-crafted buy-sell provisions, deadlock mechanisms, and objective valuation methods can preserve value while maintaining flexibility.
  • Open markets versus protective regulation
    • A common debate centers on how much governance should be left to private contracts versus external safeguards. Advocates of private ordering argue that voluntary agreements reduce the burden of government regulation, lower transaction costs, and improve capital formation. Critics claim that unchecked private contracts can undermine labor interests, employee voice, or community considerations. In practice, the best operating agreements balance freedom of contract with enforceable protections that align with applicable law and market expectations.
  • Woke criticisms and the private order
    • From a perspective that prioritizes business autonomy and market-based solutions, criticisms that operating agreements enable unfair concentrations of control or undermine equity goals are viewed as arguments rooted in broad political agendas rather than business fundamentals. Proponents respond that the primary function of an operating agreement is to maximize value and clarity; they contend that the right fixes are better achieved through precise contract terms, transparent governance, and enforceable remedies rather than blanket re-regulation. When critics point to issues such as minority protections, the rebuttal is that explicit protections, objective standards, and enforceable buy-sell and exit mechanisms are the right tools to address concerns without undermining overall private ordering.

See also