Table of Contents
Let me tell you about two people who used to be friends before they formed an LLC together. I’ll call them Wednesday and Enid, who started a candle business together. Great product, real audience, genuine enthusiasm. At first they split the work pretty evenly. But over time, Enid ended up doing maybe 70% of the day-to-day work and Wednesday was doing 30%. Enid wanted to bring on a third partner who had some capital to invest. Wednesday said absolutely not. Enid wanted to reinvest the profits back into the business to fund growth. Wednesday needed to pull her share out. And eventually Enid said, “I want to buy you out. What’s your share worth?” And they had no answer to that question. No agreed-upon formula. No process. Just two people who used to be close friends, now sitting across from each other with a lawyer on each side, trying to figure out what their agreement meant, except there wasn’t one.
This is not a rare story. I have had so many consultations that start with some version of “we had a handshake agreement” or “we figured we’d work it out as we went.” And every single time, I think the same thing: if you had just spent a few hours with an attorney before you started, you would not be spending months, maybe years, and many thousands of dollars trying to clean this up now.
This post covers operating agreements: what they are, what they do, what happens when you don’t have one, what absolutely has to be in yours, the most common mistakes I see, including the ones that will genuinely ruin a friendship or a business, and the questions I hear most often.
If you have an LLC, whether you formed it yourself online or had an attorney or CPA set it up for you, keep reading. Even if you’re a solo business owner with no partners, because I’m going to explain why single-member LLCs need operating agreements too, and what happens when they don’t have them.
What Is an Operating Agreement?
An operating agreement is a legal contract that governs how your LLC is run. It is the rulebook for your business. It covers things like who owns what percentage, how decisions get made, how profits and losses are distributed, what happens when someone wants to leave, whether you can force someone out and when, what happens if someone dies or is incapacitated, how you bring in new members, and what happens if the business closes.
Every state allows LLCs to have operating agreements. Some states require them. Most states allow them to be oral, meaning not written down anywhere. That should immediately alarm you, because an oral operating agreement is functionally an invitation to a dispute.
Some states do require a written operating agreement, even for a single-member LLC. But even in states that don’t require one, you should always have one. In writing. Signed by everyone.
Here is something about LLCs that I want you to understand: an LLC is incredibly flexible as a business structure. That is one of the reasons it’s so popular. Corporations are more rigid; there are more rules set by state law that corporations have to follow, and there is not a lot of room for customization. LLCs are different. The law essentially says: we will give you some default rules, but your operating agreement can override most of them. You can design your LLC’s governance almost any way you want, as long as you put it in the operating agreement. You can also have some flexibility about how you’re taxed.
That flexibility is a feature. But it also means that if you do not specify, you fall back on the state’s default rules. And the state’s default rules were not written with your specific business in mind.
Let me give you one quick example. In many states, the default rule for an LLC is that profits are distributed equally among all members, regardless of how much work each person does or how much capital they contributed. If Wednesday put in twenty thousand dollars and Enid put in five thousand dollars but they have a fifty-fifty ownership split, the default says they get equal shares of profit. That might be exactly what they want. Or it might be the source of enormous resentment. The state does not care which outcome is right for your business. Your operating agreement does.
Single-Member LLCs: Don't Skip This Section
This one comes up constantly, so I want to address it directly for solo LLC owners, though if you have multiple members, everything here applies to you too.
“I don’t have partners, so I don’t need an operating agreement.” While in most states that is legally true, conceptually that is wrong, and here’s why.
First: limited liability protection can be stripped away. The whole point of an LLC is limited liability protection. That protection can be taken away if a creditor or a court decides your LLC is not really a separate entity, that it’s just you doing business with an LLC label slapped on top. This is called piercing the corporate veil, which is as dramatic as it sounds. It means you lose the liability shield an LLC provides and your personal assets, like your house, are at risk. One of the factors courts look at when deciding whether to pierce the veil is whether you actually operated like a real business entity. Having an operating agreement is evidence that you did.
Second: banks want to see it. If you want to open a business bank account—and you absolutely should have one if you have an LLC—many banks will ask for your operating agreement. Not your articles of organization. The operating agreement. Why? They want to see who has the authority to open the account. For single-member LLCs this may seem like overkill, but banks are heavily regulated and may have internal rules requiring them to check regardless of LLC size.
Third: succession planning. This one does not get talked about enough. If anything happens to you, your operating agreement can specify what happens to your LLC. Who steps in? Who manages it? Can your family members inherit your interest? Without an operating agreement, this gets messy and expensive and state-law dependent in ways you do not want your family to have to deal with.
So yes, single-member LLC owners, you need an operating agreement.
What Your Operating Agreement Must Cover
Here are the major provisions that belong in every operating agreement. This isn’t an exhaustive list. Yours will likely have unique issues to address, but these are the ones that are critically important for most LLCs.
Ownership and Capital Contributions
Who owns what? This sounds obvious, but write it down clearly and explicitly. List every member, their ownership percentage, and what they contributed to get that percentage. Capital contribution means what they put in, whether that’s cash, property, services, or intellectual property.
This section matters because ownership percentage is often the basis for profit distributions, voting rights, and what happens when the business winds down. If it is not written down clearly, you will fight about it later.
Also think about what happens when the business needs more money. Does everyone have to contribute? In proportion to their ownership? Can one member contribute more and get a larger stake? What if someone can’t or won’t contribute? Do votes about all that have to be unanimous? Your operating agreement should have answers to these questions before they come up.
Profits, Losses, and Distributions
How does money move in your business? Specifically: how are profits and losses allocated among members, and when do distributions happen?
Allocation and distribution are two different things. Allocation is how profits and losses are divided on paper. It affects your tax return. Distribution is when money goes from the business to the members. An LLC can allocate profits equally but choose to hold the money in the business rather than distribute it. Your operating agreement should specify both the allocation formula and the rules around when distributions happen.
This is also where you would address guaranteed payments, when a managing member gets paid for their services regardless of whether the business is profitable. It functions more like a salary. If Enid is running day-to-day operations and Wednesday is more of a passive investor, Enid might receive a guaranteed payment as compensation, separate from whatever profit distributions happen.
Management Structure
There are two basic management structures for an LLC: member-managed and manager-managed.
In a member-managed LLC, all the members participate in running the business. Everyone has a say in day-to-day decisions. This works well for small businesses where everyone is actively involved.
In a manager-managed LLC, one or more designated managers run the company. The managers might be members, or they might be outside people hired to manage. The non-managing members are essentially passive investors.
Your operating agreement should clearly establish which structure you are using, who the manager or managers are, and what their authority is. What decisions can a manager make without checking with anyone? What decisions require a vote? This is where vague language causes serious problems. “Manager has authority to conduct business in the ordinary course” sounds fine until you are arguing about whether hiring a two-hundred-thousand-dollar employee was ordinary course or not.
Voting Rights and Decision-Making
Who gets to vote on what, and how much does their vote count? In many LLCs, voting rights are proportional to ownership percentage. But they do not have to be. You could have an LLC where everyone gets one vote regardless of how much they own, or where certain members have stronger voting rights on particular issues.
Your operating agreement should specify what decisions require a simple majority, what decisions require a supermajority (like two-thirds or seventy-five percent) and what decisions require unanimous consent of all members. The more specific you are here, the fewer fights you will have later.
Voting information should also address what happens in a tie. Does one member, officer, or outside party get a tiebreaking vote? Does a deadlock mean the status quo remains? This needs to be spelled out.
Restrictions on Transfer
Can a member sell or give away their ownership interest? To whom? Under what conditions?
This is critically important for multi-member LLCs. If your partner can freely sell their forty percent stake to a stranger, you might suddenly be in business with someone you have never met and do not trust. Most operating agreements include a right of first refusal, meaning if a member wants to sell, they have to offer the other members the chance to buy first, at the same price and terms.
Some operating agreements restrict transfers entirely. You cannot transfer your interest without the consent of all other members. This is very common for small, closely held businesses where the personal relationship between the owners is part of what makes the business work.
Admission of New Members
What happens if you want to bring in a new owner? How does that process work? What vote is required? Does every existing member have to agree?
If you do not address this in your operating agreement, you may end up with a default rule that is not what you intended. Remember Wednesday and Enid: the dispute over whether to admit a new capital investor was one of the things that started their unraveling, and they had no agreed-upon framework for how to make that decision.
Buy-Sell Provisions
This is the section that saves friendships. Possibly also businesses.
A buy-sell provision, sometimes called a buyout provision, is the set of rules for what happens when someone wants out or has to get out. It should cover voluntary withdrawal: what happens if a member wants to leave? Can they just walk away? Are they entitled to a buyout? How is their interest valued?
It should cover death or disability: if a member dies or becomes permanently disabled, what happens to their interest? Does it pass to their heirs? Does the business have the option to buy it back?
And it should cover deadlock. If you have a fifty-fifty partnership and you reach a true impasse where neither person will move, how do you resolve it? Some operating agreements use what’s called a shotgun provision or a Texas Shootout clause, where one partner names a price, and the other partner can either buy them out at that price or sell their interest at that price. It is a pretty dramatic mechanism. But it works, because it forces the person naming the price to be honest about what the business is actually worth.
The buyout valuation formula is particularly important. Are you using book value? A multiple of earnings? A fair market value appraisal? Agreeing on the formula in advance, when everyone is optimistic and the relationship is good, is so much better than fighting about it when someone is already walking out the door.
Dissolution
What happens when the business ends? What triggers dissolution? Is it voluntary only, or are there automatic triggers? How are assets distributed after debts are paid? Who is responsible for winding up the company’s affairs?
Common Mistakes
These are the LLC operating agreement mistakes I see most often, and most of them are completely avoidable.
Mistake 1: Using a Template Without Customizing It
I understand why people do this. Templates are cheap and easy. But an operating agreement is not a document where one size fits all. State laws vary. That’s why I don’t sell a template based in Illinois law that someone in Texas might buy and think works fine for Texas law. Your business structure is unique. The dynamics of your ownership group are specific to you and your situation.
The most dangerous version of this mistake is when someone downloads a multi-member template from a free legal website and fills in the names and percentages without really reading it. The template might have default provisions that are completely wrong for their situation, like a deadlock resolution provision that requires buying out a member at book value, when the business’s actual value is almost entirely in its brand and customer relationships, things that would never show up on a balance sheet.
A template is a reasonable starting point. It is not a finished product.
And you may be surprised to know that most lawyers won’t start with a template you bring to them and just improve on it. It’s usually less expensive to have us draft an agreement from the start than to review one to see what is and isn’t in it and how what is in it will work with provisions we add. When we start from the beginning, we don’t have to waste time on all of that.
Mistake 2: Not Having One At All
If you have an LLC right now with no operating agreement, please go get one. It does not matter if you have been in business for five years and everything is fine. You need this document before things stop being fine.
I have seen genuine, longstanding friendships end over business disputes that a clear operating agreement would have resolved in an afternoon meeting. Please get the document.
If cash flow or time are tight, then get a good template based on your state law as a stop gap. LegalZoom is better than nothing. Just make sure to have a lawyer draft a tailored one as soon as you can.
Mistake 3: The Agreement Is Outdated
Your operating agreement was written when the business was formed. It might have been perfectly appropriate then. But businesses change. Ownership changes. Management changes. You bring in new members, buy out old ones, pivot your entire business model. If your operating agreement does not reflect what is actually happening in the business, it is a problem waiting to surface at the worst possible time.
Review your operating agreement every year or two, and definitely review it whenever something significant changes in the ownership structure or direction of the business.
Mistake 4: The Agreement Is Ambiguous
Vague language is almost worse than no language, because it creates the illusion of an agreement without actually resolving anything. “The manager will receive reasonable compensation” is not a number. “Distributions shall be made periodically” does not tell you when. “Major decisions require approval of the members” does not define major.
Your operating agreement should be specific. Real numbers, real processes, real timelines. If you are going to make distributions quarterly, say quarterly. If the manager is going to earn a salary of sixty thousand dollars a year, say sixty thousand dollars. Specificity is your friend.
Mistake 5: Ignoring the "What If It Goes Wrong" Scenarios
People are optimistic when they start a business. Nobody wants to think about death, disability, divorce, or deadlock when they are excited about launching something. But your operating agreement is precisely the document that should address those scenarios, because it is the only time you will be able to agree on the rules without an emotional stake in the outcome.
When I work with clients on operating agreements, I always ask them to think about the worst version of their business relationship. What would the most disruptive scenario be? What would cause the most damage if it happened with no plan in place? And then we make sure the operating agreement addresses it. Sometimes I say my job is to be a professional worrier so I can help clients avoid potential problems. Worrying and addressing the issues from the start isn’t pleasant, but it’s far more unpleasant to worry that you won’t be covered if things going wrong or only start to think about problems when they occur or are about to.
It doesn’t matter if you’re friends or family. In fact, those are the relationships for which things get the most ugly when something goes wrong. I’ve seen best friends end up hating each other. I’ve seen families divided with siblings no longer speaking to each other. That didn’t have to happen.
Mistake 6: Not Getting It Properly Executed
An operating agreement is a contract. It needs to be signed by all members to be binding. I have seen situations where someone drafted a solid operating agreement, distributed it to all the members, most people signed it, and one person never did, and then that one person, naturally, was the one who later disputed its terms. Make sure everyone signs. Make sure you keep signed copies somewhere you can find them. And make sure the signatures are dated. Have them notarized if you want to.
Mistake 7: Treating It as a One-and-Done Document
Some business owners think of the operating agreement as something you do when you form the LLC and then file away in a drawer forever. It is not. It is a living document. Every time the business has a significant development—new members, buyouts, changes in how the business is managed, acquisition of major assets—you should be asking whether the operating agreement needs to be updated or amended. Ask your lawyer.
Mistake 8: Ignoring Intellectual Property
This one is specific to the kind of work I do, and I flag it because it trips up so many small business owners. If members are contributing intellectual property to the LLC (brand names, inventions, creative work, software, trade secrets), your operating agreement needs to address the ownership and licensing of that IP very clearly.
Who owns the IP? The LLC or the individual members? If it is the LLC, what happens to it when the LLC dissolves? If a member leaves, do they take their IP with them? Can they use it to compete with the business? Who is in charge of renewal and maintenance?
Operating agreements that are completely silent on IP while one member contributes a trademarked brand name to the business and then leaves end up with a dispute over that brand name that is enormously expensive and complicated in ways that have nothing to do with how good the attorneys are, and everything to do with the fact that nobody wrote down who actually owned the name. Do not let that be you.
Practical Takeaways
Here is what I want you to do with what you’ve just read.
If you have an LLC and no operating agreement: this is at the top of your list. Stop treating it as something you will get around to eventually. Get it done.
If you have an LLC and an operating agreement you downloaded from the internet and have not really read: read it. Actually sit down with it and go through it. If you do not understand a provision, ask an attorney to explain it. If it does not address your actual situation, get it updated.
If you have a multi-member LLC and your operating agreement does not have a clear buy-sell provision with a valuation formula: fix that. The time to agree on how you would value a buyout is when you don’t need to do one, not when you do.
If you have a single-member LLC and you still think you do not need an operating agreement: I hope this post changed your mind.
And if you are about to form an LLC, with partners or on your own, please consider talking to an attorney before you finalize anything. Not because you cannot do any of this yourself, but because the decisions you make upfront are so much less expensive to get right the first time than to undo later, if they even can be undone.
Frequently Asked Questions
Do I have to file my operating agreement with the state?
No, and this surprises a lot of people. In almost every state, your operating agreement is a private document. You do not file it with anyone. You keep it in your own business records. This is different from your articles of organization, which you do file with the state when you form the LLC.
Can I use a free online template?
You can, but understand what you are getting. Free templates are generic. They are almost always not written for your state’s specific laws, and even if they are, they are not written for your specific business. For a very simple single-member LLC with no unusual circumstances, a template might be an adequate starting point. For a multi-member LLC, especially one where the members are contributing different amounts of money, time, or intellectual property, I strongly recommend working with an attorney.
My LLC has been operating for three years with no operating agreement. Is it too late?
It is never too late. Go get one. The fact that you have been operating without one means there may be some ambiguity around things like what each person’s contributions have actually been and what the current arrangement really is, and an attorney can help you document what has happened and build the agreement around your current reality. It is more work than doing it at formation, but it is absolutely worth doing.
My business partner and I are also married. Do we still need an operating agreement?
Yes. I know it feels overly formal, but married business partners have all the same potential for disagreement as any other business partners, and the added complexity of divorce law on top of business law makes the operating agreement more important, not less. If you live in a community property state, this is especially true.
What is the difference between an operating agreement and a partnership agreement?
A partnership agreement governs a general partnership or a limited partnership. An operating agreement governs an LLC. They serve similar functions. They are both the internal governing document for the business entity, but they are different documents for different types of business structures. If someone hands you a partnership agreement for your LLC, that is a mismatch worth flagging.
What happens if our operating agreement conflicts with state law?
It depends on the provision. Some state LLC statutes set default rules that your operating agreement can override. Other provisions are mandatory: they are set by law and cannot be changed by private contract. In general, LLC law gives you a lot of flexibility, but there are limits. An attorney who knows your state’s LLC statute can tell you which provisions you can customize and which you cannot.
Can we amend our operating agreement after the fact?
Yes. Your operating agreement should include a provision describing how it can be amended—typically some vote threshold of the members. As long as you follow that process, you can amend it. If your operating agreement somehow does not address amendments, you would typically need unanimous consent of all members to make changes.
Does my operating agreement need to be notarized?
In most states, no. Signatures of all members are sufficient. There are some narrow exceptions. For instance, if your operating agreement involves transferring real property into the LLC, you may need notarization for that specific transaction. This is state-specific and worth confirming with an attorney.
My business partner and I have been friends for fifteen years. Do we really need all this?
Yes. The operating agreement is not a sign of distrust. It is actually the opposite. It is the two of you saying: we trust each other enough to be honest right now about what we each expect. Let’s write it down while the relationship is good, so neither of us is ever put in the position of relying on the other person’s memory of a conversation we had five years ago. The friendships and partnerships that survive business disputes are the ones where there was a clear agreement from the beginning.
How much does an operating agreement cost?
It varies a lot depending on complexity and the attorney. For a simple single-member LLC, it might be a few hundred dollars. For a complex multi-member LLC with detailed buy-sell provisions and intellectual property assignments, it will be much more. Many attorneys, including me, offer flat-fee business formation packages that include the operating agreement as part of the package. The cost of getting it right upfront is always a fraction of the cost of litigating a dispute later.
Ready to Get Your Operating Agreement in Order?
Download the free Operating Agreement Checklist, a three-page reference covering important provisions your agreement should address, whether you’re building from scratch, reviewing an existing one, or preparing to meet with your attorney: A 5-Question Check on Your LLC Operating Agreement: Potent Potion or Poisonous Brew?
If you have questions about your specific situation, I offer business law consultations. I’m licensed in Illinois, so if you are an Illinois business owner, I can work directly with you on your operating agreement. If you are outside Illinois, ask your trusted business associates or friends for a referral, or check with your state or local bar association.
Next up: IP Legacy Part 2: The Digital Graveyard. What happens to your social media accounts, domain names, and online business presence when you’re gone? That one is coming up soon and it is genuinely important for anyone who has built any kind of digital presence.
The legal horror stories I’ve seen almost always follow the same plot: someone built something valuable and didn’t protect it, or signed something they didn’t understand, or waited until the damage was already done. You don’t have to be in that story.
I help entrepreneurs, creators, and small business owners across the U.S. make smart, legally sound decisions about their IP: patents, trademarks, copyrights, and trade secrets. For Illinois and Georgia clients, I also review brand deals, content creation, and marketing contracts. Book a consultation at kingpatentlaw.com or call 217-714-8558.
Spellbinding IP podcast on all major platforms. @kingpatentlaw on social media.
