Step-by-Step Guide: How to draft an LLC Operating Agreement in California
 

Introduction

Forming a limited liability company (LLC) can be an important step for many small businesses and startups. An LLC operating agreement is a crucial legal document that outlines the ownership structure, member responsibilities, profit/loss distribution, and other rules for running an LLC.

Drafting your first LLC operating agreement may seem daunting, but having a quality agreement in place can help set your new business up for success. This comprehensive guide will walk you through the key steps and considerations for creating your own custom operating agreement.

What is an LLC Operating Agreement?

An LLC operating agreement is a legally binding document that governs the operations of a limited liability company. It establishes the rights and responsibilities of LLC members and provides rules and regulations for the LLC’s ownership structure, management, member voting, profit/loss distribution, and more.

While LLC operating agreements are not required in all states, they are highly recommended for every new LLC to define the parameters of the business and prevent future disputes between members. The agreement should be customized to fit the specific needs of your LLC.

Why You Need to Write an Operating Agreement – Step One

Here are some of the key reasons why your LLC needs an operating agreement:

  • Outlines member roles, voting rights, and ownership percentages
  • Sets rules for member contributions and distributions
  • Defines LLC management structure and decision-making processes
  • Establishes procedures for member changes (adding or removing members)
  • Specifies policies for member withdrawal or transfer of interests
  • Sets ground rules for how disputes will be resolved
  • Provides rules for dissolution and winding up of the LLC

In short, the operating agreement is your LLC’s governing document and roadmap for how membership and management will work.

LLC Formation – Drafting Your Initial Written Operating Agreement

Drafting your first LLC operating agreement may seem intimidating, but it can be broken down into several key steps:

Choose Your Management Structure

One of the first decisions you and your co-members must make is whether your LLC will be member-managed or manager-managed. This determines how your LLC will be governed:

  • Member-managed – All members participate equally in managing the operations. Decision-making and voting power is distributed amongst members.
  • Manager-managed – The LLC is managed by appointed managers (can be members or non-members). Managers have decision-making authority, while members have limited control.

Discuss with your members which structure makes the most sense for your LLC based on your experience, business needs, number of members, etc.

Establish Ownership Percentages

You’ll need to determine each member’s ownership percentages and equity distribution. Typical approaches include:

  • Equal distribution – Each member gets an equal share of ownership. It’s simple but not always the best fit.
  • Proportional to contributions – Members receive ownership stakes proportionate to their financial and non-financial contributions
  • Performance-based – Ownership is tied to members’ contributions and responsibilities in the LLC.

Ensure the total adds up to 100% and document each member’s percentage in the operating agreement. Consider including vesting schedules if certain members need to earn their total equity share over time.

Appoint a Registered Agent

Every LLC must designate a registered agent, which is a person or service that receives essential legal documents and communications on behalf of your business. Choose a registered agent service or individual in your state who can perform this role. Document the registered agent’s name and contact information in your operating agreement.

Define Member Responsibilities

Clearly outline the roles, responsibilities, and duties of each member of the LLC. For member-managed LLCs, this means defining what each member is expected to contribute from a time and effort standpoint. For manager-managed LLCs, focus on the duties and obligations of appointed managers.

Establish Profit/Loss Distribution

Decide how your LLC will handle the distribution of profits and losses to members. Common approaches include pro-rata distributions based on ownership percentage or more complex tiered distribution waterfall schedules. Also, consider if special allocations (distributions not tied to ownership percentage) are needed for specific members.

Set Up Capital Contributions

Outline the initial and any additional capital contributions required from members. Define the contribution amount, form (cash, property, services, etc.), and timeline for making contributions. Also, determine how you’ll handle non-payment if a member doesn’t make their required contribution.

Select a Business Tax Structure

Decide if your LLC will be taxed as a sole proprietorship, partnership, S corporation, or C corporation. Your tax election and structure affect how profits/losses flow to members, so pick the best fit for your needs.

Plan for Member Changes

Please take a look at situations where members join or leave your LLC and how you’ll handle member dissociation. Typical provisions include the right of first refusal rules, transfer, and assignment of membership interests, valuation procedures, and whether the LLC has the option to purchase the departing member’s shares.

Set Up Dispute Resolution Processes

No one likes to think about it, but disagreements can happen. Outline procedures for resolving member disputes through mediation, arbitration, or litigation. A dispute resolution plan can preserve relationships and avoid dissolution.

Allow for Dissolution of the LLC

As a final provision, establish ground rules for dissolving your LLC. Identify dissolution triggers like a member vote, withdrawal of a member, or a violation of the operating agreement. Also, outline the dissolution process and winding up of business operations.

Conclusion

Drafting your first LLC operating agreement takes time and planning, but the investment is well worth it for protecting all members’ interests in the business. Be sure to cover the critical elements outlined in this guide, work closely with your co-members, and don’t be afraid to get help from legal counsel. With a solid operating agreement in place, you’ll be setting your new LLC up for success.