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Key Takeaways
- An Operating Agreement (OA) spells out the agreed processes of a Limited Liability Company (LLC).
- In the absence of an OA, an LLC will be governed by default state rules.
- Though many OAs contain similar formats and language, there is no legal standard, and every document should be tailored to its individual business.
- An OA is only as effective as its contents, and it is advisable to consult an expert to ensure it is fit for purpose and legally compliant.
Are you considering incorporating your business internationally? To protect your interests, it is crucial to get an operating agreement in place. Here we explain how operating agreements work and how they can protect your financial position.
What is an Operating Agreement?
An Operating Agreement (OA) is an official document that specifies the structure and procedures of a business entity, usually a limited company. In the US, this is usually a Limited Liability Company (LLC) or a corporation. In Hong Kong this is a limited company, in China a WFOE, and in Malaysia, a private limited company (Sdn Bhd). It establishes who the entity’s members/shareholders are, what responsibilities, rights, and powers they have, and how the company is governed.
An OA is a useful way of codifying informal agreements about how meetings should be run and decisions made. It can cover a range of topics, from ownership splits and voting rights to profit distribution and how to handle succession plans and potential buyouts.
While it is not mandatory in every location to produce an OA when forming or running a limited company, it is always advisable as it allows the entity to take full control of its operations. If no OA is in place, it is legally assumed the entity will be governed by standard processes laid out by the country or state laws. These are necessarily general in nature and may not be right for every individual business.
In addition, an OA presents an opportunity to add another layer of protection in preventing individual members from being held personally liable for the company’s business obligations or debts. Without an OA, some courts may not recognize the separation between the individual and the company that establishing a limited company is designed to create.
Note, while OAs should be applied to all business entities, for simplicity’s sake, here we use the example of US LLCs.
Setting up a WFOE or overseas holding structure? MSA helps align operating agreements and Articles of Association with China’s corporate governance requirements. Message →
What Are the Key Components of an Operating Agreement?
The contents of an OA can vary from business to business and state to state. Most are between five and 20 pages long, but there are a few mandatory sections, and each section will be structured in accordance with the individual needs of the LLC and its members.
There are, however, several elements that should be considered for an effective OA:
- Basic business information. This could include the LLC’s official name, principal address, length of operation, and a copy of its statement of purpose. It is also common to include the management structure and details of the registered agent.
- Member information. This can include member names and other relevant personal details, roles within the LLC, and percentages of ownership. It can also feature voting rights, profit and loss allocation, and provisions to be made in the event of departure or death.
- Operating procedure. This is how meetings should be structured, including responsibilities for taking minutes and holding votes. It could also include the powers and duties of managers and who has a right to take certain decisions or actions on behalf of the business.
- Tax treatment. In most circumstances, LLCs are taxed based only on members’ personal returns. However, this is not the only option, and alternative tax structures can be chosen. If this is desirable, tax arrangements should be detailed in the OA.
- Limited liability. By clearly defining the separation between the obligations of a business and its members, LLCs can create the highest level of protection for their interests. While forming an LLC can be enough in some circumstances, adding a limited liability statement to its OA helps defend this arrangement if questioned.
Operating Agreement vs Statutory Default Rules
| Governance Area | With Operating Agreement | Without Operating Agreement |
|---|---|---|
| Ownership & Voting | Clearly defined by members | Determined by statutory defaults |
| Profit Distribution | Customisable | Fixed by law |
| Management Powers | Allocated by agreement | Assigned by statute |
| Dispute Resolution | Pre-agreed mechanisms | Litigation or arbitration by default |
| Liability Protection | Stronger evidentiary support | Higher risk of veil-piercing |
| Succession & Exit | Defined buyout rules | Governed by law, often rigid |
What Are the Challenges in Drafting an Operating Agreement?
Perhaps the biggest challenge in creating an OA is that such documents do not have a clear set of legally mandated requirements. This leaves drafting open to interpretation and allows weaknesses to arise through poor language, missing sections, or a lack of thoroughness in execution.
Typical failures that can occur when drafting an OA include using ambiguous language or allowing potential loopholes. Often, sections that would be valuable can be omitted while the document becomes cluttered with those that are unnecessary. Finally, it is surprising how regularly an LLC member will attempt to rely on an OA only to discover that it has not been signed, thus casting doubt on its validity.
One of the best ways to address and resolve these issues is to hire a specialized lawyer or independent service that has experience and expertise in this area. This not only helps ensure the OA serves its purpose for the LLC and its members, but that it is also legally compliant and can be relied upon when needed.
What Are the Best Practices for Operating Agreements?
When drafting an OA, whether in-house or with the assistance of a lawyer, there are several ways to help ensure the final document is complete and effective. One of the best strategies is to consider hypothetical scenarios and research case studies.
By imagining the situations and potential issues that might later occur, or becoming familiar with those that have happened previously in other organizations, it is possible to attain a much clearer idea of what needs to be included in an OA. Asking “What if?” and “What has happened?” is a great way to prepare for what might happen later.
Another best practice tip for creating an effective OA is to go through each element of the business’s regular processes and see where disputes or confusion are found. Discuss the ownership structure, decision-making, voting processes, how deadlocks are resolved, how taxes are filed, and what will happen when one or more members exit the company. Wherever something is unclear or possible to misinterpret, include in it the OA.
Getting an Operating Agreement in Place — Our Take
An OA is crucial to protect the interests of parties in both an American LLC, and limited companies in any other jurisdiction. If you would like support with your operating agreements for your international subsidiaries, get in touch with MSA’s incorporation experts.
Operating agreements spell out governance rights, profit distribution, and dispute resolution procedures—details often assumed but rarely documented, creating ambiguity when partnerships face operational stress or exit decisions. Clarity at formation prevents costly disputes later. China corporate services include operating agreement drafting aligned with your partnership structure. MSA Asia establishes clear governance from day one. Speak with us about structuring your operating agreement.
When an OA does not exist, the operations and responsibilities of an LLC and its members default to the standard processes laid out by the state. As every business is different, it is unlikely these will provide an exact best fit and may not offer the required clarity or protection at all.
An OA protects the members of an LLC by ensuring everything is agreed, unambiguous, and indisputable. It allows everyone to know exactly where they stand. When including a limited liability statement, it also helps protect members from being held personally accountable for any debts or obligations held by the business.
