What is an Operating Agreement?
An operating agreement is a key legal document for owners of an LLC or limited liability company. The agreement includes details regarding the structure for organizational and operational management of the business. Among other responsibilities, the operating agreement defines the ownership of the LLC and the ownership function of each member.
Ownership Percentages
At the time of formation, the operating agreement enables each of the co-founders to be designated as a member and to receive a percentage of ownership that will carry through the duration of the life of the LLC. For instance, if three members of an LLC agreed to start a business with membership of 15 percent per individual, the information is detailed in the operating agreement. If one of the three members later sells a portion of his percentage to a fourth member, the operating agreement is updated to reflect the current members and the percentage of their individual ownership.
Duties and Authority
The roles of officers and managers are designated in an operating agreement. This document allows each participating individual to have a level of authority to manage the company rather than having to address the responsibilities with the other members . Resolution of any major issues within the company must be made according to the terms of the operating agreement. In the operation of a corporation, the primary manager might be the president. In the standard operating agreement for an LLC, the primary manager could be the vice president with the president serving as a member. In an LLC with a board of directors, the president has more authority.
Managed Members and Members at Will
With operating agreements in place, individuals are described in a manner similar to a corporation. Managers in an LLC are responsible for day-to-day operations. When an LLC has a board of directors, members are responsible for decisions such as: An LLC often has members at will who are not concerned with management or control of the business. Under this situation, the operating agreement does not require changes as decisions are frequently made by a few individuals involved in management.
Special Rights
Members of an LLC may have special rights and certain restrictions. In an operating agreement, there can be additional protections for the members. For instance, no future member can be able to sell his or her membership interest without the consent of all existing members. With a typical corporation, a new shareholder does not need to obtain approval from others.
What Are Bylaws for Corporations?
Bylaws are specific for each corporation and provide rules for the corporation’s day-to-day operations. They cover all internal activities of the corporation and govern the powers of shareholders, directors, officers and employees. The primary purpose of the bylaws is to govern how the corporation, including its shareholders and officers, is organized and managed. It is critical that the bylaws accurately reflect the way the corporation actually operates.
The company bylaws are sometimes referred to as a company’s "rules" and usually include topics such as the number of officers and directors, officer and director powers, removing and appointing officers and directors, shareholder meeting locations, voting procedures, appointment of committees, and any provisions necessary for maintaining corporate records and accounts.
Aside from the power to elect or remove directors and officers, shareholders have a limited role in corporate governance. For example, bylaws often require that shareholders authorize any expenditure of funds above a certain amount.
A majority of states require a newly formed corporation to create bylaws, however, other states do not. A majority of states also require the corporation to maintain minutes of shareholder and board meetings and document all major corporate transactions.
Operating Agreements vs Bylaws: The Main Differences
Some key differences between operating agreements and bylaws include: The entities using the document are different. Operating agreements are used by LLCs, while bylaws are used by corporations. Both documents contain provisions concerning the management of the business; however, the specifics of these provisions can vary depending on which business structure is being discussed. For example, there are no shareholders in an LLC. Therefore, unlike a corporation, there is no need to have provisions that address the voting rights of shareholders.
Why Use a Customized Operating Agreement and Bylaws
Operating agreements and bylaws cannot be cookie cutter documents that provide a one-size-fits-all solution. Every business has different needs and requirements based on its structure and the unique goals of its owners. Moreover, the rights and obligations of the members of a company or shareholders of a corporation can vary widely. A customized operating agreement and bylaws are an essential part of forming a business. Having these documents drafted with unparalleled attention to detail will allow your company to run smoothly and operate without internal conflict.
Generally, a limited liability company is run by its members. Operating agreements typically address the management structure of the LLC, including manager-managed and member-managed, and outline the management powers of each member or manager. In addition, an operating agreement will address any vesting periods for the transfer or sale of membership interests, different classes of membership interests such as preferred membership units and special allocations, restrictions and limitation on transfer of membership interests, and voting rights on certain matters. The terms of an operating agreement can only be amended or terminated if allowed by the agreement itself or if consent to do so is obtained from each of the members.
A corporation is generally managed by its board of directors; however, shareholders of a corporation have the choice to divest over all or most of their decision-making power to corporate officers and directors through a corporate resolution. Corporations can also choose to have shareholders elect to continue or terminate a corporation by affirmative vote of the majority of the shares entitled to vote. Amendment or termination of the bylaws generally requires the affirmative vote of the shareholders at the next annual meeting.
Compliance and Legal Requirements
In many jurisdictions, there is a legal requirement for both an operating agreement and bylaws to be created for companies. As the name suggests, it is common for bylaws to be required for corporations, while it is equally common for an operating agreement to be required by law for limited liability companies. However, some states and countries do not have a specific requirement for either entity type, so it is important to investigate where the company will be registered to understand the rules that pertain to it .
Even in those states that require bylaws or an operating agreement, many have discretion with regard to enforcing these requirements and do not strictly enforce the rules. However, this does not mean that operating agreements and bylaws can be ignored, as these types of documents can protect owners and key persons in several different ways, from liability to greater protection of ownership interests. For this reason, creating an operating agreement and bylaws for any type of company is still advisable even if there is not a specific legal requirement to do so.
How to Draft Operating Agreements and Bylaws
The drafting of operating agreements and bylaws requires a careful and deliberate approach. The document must set forth the rules of operation and management that are appropriate for the specific industry and unique to the company’s structure. Key considerations include the extent to which control is vested in members or managers, how major decisions are made and how profits are shared. In addition to the articles of incorporation, it is critical that the laws of the state where the business is formed are considered prior to drafting.
Seek Out Professional Legal Counsel
While there is no bright line test regarding the length or complexity of the document, a quality operating agreement or bylaws document will typically be long and cover a broad array of topics. For this reason, it is strongly recommended that companies seek expert legal counsel when drafting an operating agreement or bylaws to ensure compliance with all relevant laws and regulations.
Common Pitfalls
Certain common mistakes and omissions should be avoided in the drafting process. Consider the following:
The operating agreement or bylaws must be in writing. Although companies are not required to use any specific number of words or pages in their respective document, it is critical that all policies and procedures are outlined in detail to diminish challenges over operational issues or disputes.
Lastly, operating agreements and bylaws can be changed if necessary. It is crucial to revisit the document on a regular basis and be open to amendments as needed.
Which Should You Use for Your Business?
When deciding between an operating agreement and bylaws, several factors can determine which document—or even whether both are appropriate for your organization. Businesses in North Carolina have many options. Your company may be a sole proprietorship, limited liability company, corporation, or a nonprofit organization. Each has its own advantages, but important differences exist between each structure.
Governing Documents
Business structures are governed by many documents. The type of governing document you need depends on the business structure: Bylaws and operating agreements differ in that corporations require bylaws, while limited liability companies require operating agreements. However, both are optional for most business entities (including limited liability companies). Corporations must have bylaws, but they’re not required to have an operating agreement. If you choose to establish an LLC or corporation, it’s important to include the appropriate governing document in addition to filing the Articles of Organization or Articles of Incorporation.
Decisions Questions
When determining whether an operating agreement or bylaws (or both) may be right for your business, ask the following questions:
Limited Liability Company Considerations
If you’re forming a limited liability company, creating an operating agreement is recommended even though North Carolina law doesn’t require it. If your company plans to seek outside investment in the future , having a distinct operating agreement can be of great benefit. An operating agreement can also provide the board of directors with a useful tool that creates better transparency and clarity in the decision-making process. If the business will be a single-member, single-class LLC with no outside investments, including an operating agreement will likely not be necessary.
Corporation Considerations
Corporations need bylaws, as they are required by law. For closely held corporations, however, on the other hand, bylaws often do not need to be highly developed from a legal standpoint. These closely held companies often have owners that serve as officers and directors, and those individuals can usually make decisions without a highly structured decision-making process.
Sole Proprietorship Considerations
All sole proprietorships are single-member, single-class organizations. Since they require no formal record-keeping or paperwork, rolling the decision-making process into a formal bylaws document is generally not necessary.
Clarity Benefits
Every business should take the time to document its decision-making process, but there are many ways to do so. Adopting bylaws or an operating agreement shows that the founders are able to conduct business in an orderly and disciplined manner. This is beneficial in any situation that involves more than one owner, no matter the size of the company.