What Exactly is an Operating Agreement?
Since an operating agreement is the document that explains how your business will operate, its importance cannot be overstated. The operating agreement may also include provisions for what happens to the owners’ interest if they were to die, retire or even want to be bought out, or even what will happen to a member’s ownership interest after the member files for divorce; it can also provide buy/sell provisions in case of an owner’s bankruptcy or sudden disability. Each of these events could have drastic consequences to a business and still be protectable with a thoughtful operating agreement.
The operating agreement may also discuss in detail how management will be appointed, how profits or losses will be allocated, how decisions regarding outside capital contributions will be made , and will set forth all the important rules of the game. If the operating agreement is silent on matters, state law will apply such that each member will have an equal right to make the decisions regarding the purportedly undefined matter. This may not be a desired result.
An operating agreement is not legally required in every state (but it is in many), however, it is suggested that regardless of whether each member of an LLC is also an owner, each entity should have an operating agreement. Capital contribution of cash, services, machinery or equipment must be properly apportioned pursuant to an operating agreement. Also, if an employee of an LLC receives an ownership stake in the LLC, the operating agreement should detail their responsibilities and obligations. If a member of an LLC is paid wages, it must be done in accordance with the operating agreement.
Defining Bylaws in Corporations
Bylaws are imperative to a corporation as they govern its internal management. Bylaws include the rules and procedures for how the corporation operates, addresses specific operational needs, and spells out the rights and responsibilities of all involved in its governance. Running a corporation without bylaws is similar to running a country without a constitution. While state law will specify the legal requirements for certain corporate actions, having bylaws provides a tailored framework for addressing issues that arise during corporate operations. Bylaws add another layer of control over the management of the corporation.
Bylaws must be adopted by the Board of Directors after the corporation is formed. State law is hard pressed to find that bylaws are not adopted, so this is rare. Failure to adopt bylaws can leave the corporation exposed to liability. Certain corporate actions require the adoption of bylaws, including the opening of a bank account and the hiring of corporate officers. By adopting bylaws, directors fulfill their due diligence and liability to the corporation.
The bylaws of a corporation in many ways track the information required of the Operating Agreement of a Limited Liability Company. Practicing attorneys who prepare both Operating Agreements and corporate Bylaws provide clients with a sense of what is necessary and helpful for their internal governance and management. A good attorney will take time to interview clients to gain an understanding of their corporate structure, as well as their direction and goals. This will ensure that the Bylaws will be suited to their needs and that the Bylaws will cover additional issues that the law may not specifically address.
Operating Agreements vs Bylaws
There are some key differences between operating agreements and bylaws that are important to understand. Those differences are particularly significant when you consider what types of entities are governed by those documents, and how the documents facilitate the governance of those entities.
In general terms, an operating agreement is a document that governs a business association that is a limited liability company ("LLC"). A bylaw is a document that governs a for-profit corporation.
Operating agreements and bylaws can govern similar subjects. For instance, an operating agreement can address the purpose or principal business of a limited liability company. It can address matters concerning ownership and distributions, and establish procedures for the transfer, assignment, withdrawal, and addition of members. It can also set forth management structures and privileges.
Bylaws serve a similar purpose in the context of corporations. They can describe the principal purpose or business of the corporation, also. They can set forth voting structures. They can even limit the transfer or assignment of stock, and establish procedures for amending the bylaws.
Despite the similarities, there are some key differences between the two documents. One difference concerns formal requirements for executing each document. Most corporations must adhere to statutory frameworks when establishing corporate bylaws. In contrast, the formal requirements for LLC operating agreements are more flexible, and determined by the State Limited Liability Company Act. For example, it is only necessary that an LLC operating agreement be adopted by a majority vote of its members, which can be accomplished before or after the limited liability company creates its first member. Meanwhile, most states require that officers of a corporation fully execute the bylaws through an authorization resolution or other similar writing attached to the bylaws. Examples of such statutory frameworks can be found in 8 Del. C., § 109 of the Delaware General Corporation Law, and 8 Pa. C.S. § 2331 of the Pennsylvania Business Corporation Law.
Additionally, the process for amending or terminating bylaws and operating agreements can be materially different as well. In most states, there are no limits on amending bylaws, so long as those amendments are made pursuant to the bylaws themselves unless otherwise specified. Conversely, many states restrict the frequency and manner in which operating agreements may be amended.
Finally, LLC operating agreements and bylaws differ in that, generally, LLCs are required to maintain an operating agreement at all times, whereas corporations are not required to maintain bylaws. Rather, bylaws are only required if the corporation chooses to adopt them.
How to Write a Thorough Operating Agreement
Essential Components
A well-crafted operating agreement should include the following components:
- Business formation details. Identify the name of the company; the type of entity (limited liability company or corporation); the address; and the state where the business was formed.
- Company ownership. Owners of the business may qualify as either members or shareholders. The company ownership section of the operating agreement must clearly explain the percentage of the business held by each member, as well as whether voting rights are based on ownership percentage or shares.
- Management. This section of the operating agreement lays out the structure of the management of the business. Is it a member managed LLC or one that is governed by a board of directors? Is it a closely-held corporation in which all stockholders are involved in running the business, or a corporation that hires an executive team and fills vacancies as they arise?
- How members can be added or removed. It is important to have clear guidelines regarding the addition and removal of company members or shareholders. While yearly mandatory buyouts or a member’s mandatory retirement at age 65 are two options for a buy/sell provision, there are many more ways.
- Formation and ownership details. Details such as the official date of formation of the company and the names and addresses of each initial member and its percentage of ownership should be included in the operating agreement. There should also be a section that outlines who receives ownership interests in the event a member dies while the operating agreement is in effect.
- Amendment provision. In the event the terms of the initial operating agreement no longer serve the best interests of the company, the agreement should outline the procedure for making changes, including any requirement for notification to members and a membership vote.
Customization
While a cookie-cutter template operating agreement may contain the essential areas that a successful operating agreement must contain, it is critical that the terms be specifically tailored to the specific business. A business services contract for a tangible company, such as a construction firm, for example, would require a different agreement than that of a high-tech or software development company.
Because there is no one-size-fits-all solution, businesses should work with experienced corporate and business law attorneys to ensure their operating ownership agreements are comprehensive and meet the needs of the company.
Drafting Thorough Corporate Bylaws
The bylaws of a corporation describe the administrative rules for the internal operation of the business. A corporation’s bylaws are akin to the organization’s password or pin number – you don’t want just any person to have them. Because they contain these internal rules, such as the number of directors, the number of meetings, shareholder voting, and a statement as to whether shareholders have cumulative voting, among many other things, corporate bylaws should be kept in confidence from public disclosure. Only the officers and directors of a corporation should know the content of the bylaws.
But as a corporation evolves, its bylaws do not remain static. Instead, they typically must be amended from time-to-time to keep up with changes in technology, the law, and the structure and operation of the company. For example, it was common for corporations to require a "meeting" in order for shareholders to approve matters relating to the company . Such meetings were required to comply with specific statutory requirements for notice, agenda, and minutes, which would be filed in the corporate book. But with modern technology, whole companies can now meet on-line or through webinars. In light of this updated technology, does your corporation need a separate bylaw provision to allow for meetings such as these? Or are these additional provisions unnecessary? Where do you start if your corporation needs to amend its articles of incorporation and bylaws?
In amending the bylaws, you will probably want to amend the articles of incorporation as well. The Arizona Corporation Commission provides a sample tutorial for how to do both – they are essentially similar, but the articles of incorporation are filed with the public records and require filing fees while the bylaws are not filed and do not, generally, require filing fees. (Note: If you do not include all of the required elements for the articles of incorporation, the Arizona Corporation Commission may require you to file the requisite amendment or restated articles along with the amendment.)
Legal Considerations and Compliance
Beyond operational and structural considerations, operating agreements and bylaws have significant legal implications for the respective entities. Despite the for-profit or nonprofit designation, the law views both types of entities as separate from their owners and directors. This means that both for-profit and nonprofit entities need to adopt certain foundational documents, including an operating agreement or bylaws, to ensure they are structured and operated in a way that complies with the law. Certain provisions, such as conflict of interest or indemnification provisions, may also be required by law.
Failing to adopt certain required organizational documents or including required provisions within those organizational documents can have serious consequences, including being subject to administrative dissolution or other actions that may jeopardize the shareholders’ or members’ status. Documents that are not properly adopted or that include unlawful provisions may also be null and void if challenged or censured by a court or administrative authority.
State Requirements Compared
While the differences between operating agreements and bylaws can be minimal, state requirements may dictate distinct provisions in these documents. The requirements of some states do not clearly delineate the obligations for operating agreements compared to bylaws, meaning that content distinctions may vary.
For example, the Delaware Limited Liability Company Act outlines the responsibilities of an LLC in its Articles of Organization and Operating Agreements. However, like some other states, Delaware does not have equivalent requirements for Bylaws as a necessary part of its business organizations statutes.
In states where corporations have similar requirements, an examination of provisions may provide further clarification. New York’s Business Corporations Law serves as an example of this . Article 4 of the New York law provides very specific elements to be included in Corporate Bylaws, including rules and regulations for share transfers and meetings.
The Oklahoma statutes, meanwhile, require a more generic approach, requiring that bylaws set forth the powers of the officers and directors and also referring to bylaws as the "regulations" of the corporation. This may be taken as further evidence that standard operating procedures are often interchangeable when it comes to the hierarchical organization of a business.
Clearly, a number of factors, including your state’s laws, the structure of your company, as well as your individual needs, can influence the contents of your Operating Agreement and Bylaws. It is always advisable to discuss these options with your legal professional.