10 Operating Agreement Clauses Lawyers Say You Can't Skip
The critical clauses that protect your LLC and prevent costly disputes
After reviewing hundreds of LLC operating agreements and mediating countless business disputes, legal experts agree: certain clauses are absolutely non-negotiable. Skip these at your peril.
Warning from the Trenches
"I've seen partnerships dissolve, lawsuits filed, and businesses destroyed—all because founders skipped 'obvious' clauses in their operating agreement. Don't let this be you."
— Business Attorney with 20+ years experience
Why These Clauses Matter
An operating agreement is your LLC's foundational document. It defines ownership, management structure, profit distribution, and procedures for major decisions. Without the right clauses, you're operating on borrowed time until the first dispute arises.
The 10 Non-Negotiable Clauses
Member Capital Contributions
What it does: Documents who contributed what (cash, property, services) and when. Establishes initial ownership percentages.
Must Include:
- Exact dollar amounts or property values contributed
- Contribution dates and deadlines
- Ownership percentage for each member
- Consequences for failing to contribute
- How additional capital will be raised
What Happens If You Skip It:
Disputes over who owns what percentage. Courts may distribute ownership equally regardless of actual contributions. Members can claim they contributed more than documented.
Example Clause: "Member A shall contribute $50,000 in cash by January 15, 2025, representing 60% ownership. Member B shall contribute equipment valued at $33,333, representing 40% ownership. Failure to contribute by the deadline shall result in proportional reduction of ownership interest."
Profit and Loss Distribution
What it does: Defines how profits (and losses) are split among members. Can differ from ownership percentages.
Must Include:
- Distribution percentages for each member
- Timing and frequency of distributions
- Whether distributions are automatic or discretionary
- Tax distribution requirements (for pass-through taxation)
- Restrictions on distributions when LLC has debt
What Happens If You Skip It:
State default rules apply (usually equal distribution regardless of contribution). Tax issues arise when members don't receive distributions to cover their tax liability. Fights over when and how much to distribute.
Pro Tip:
Always include a "tax distribution" provision requiring minimum distributions to cover members' tax liability, even if you're reinvesting profits.
Management Structure and Voting Rights
What it does: Establishes who makes decisions and how. Member-managed vs. manager-managed.
Must Include:
- Management structure (member-managed or manager-managed)
- Voting percentages (per capita vs. proportional to ownership)
- Major decisions requiring supermajority or unanimous consent
- Day-to-day operational authority limits
- Meeting requirements and quorum rules
What Happens If You Skip It:
Paralysis when members disagree. Minority members can block critical decisions. Unclear who has authority to sign contracts or make purchases. Legal liability for unauthorized acts.
Example Decisions Requiring Supermajority: Admitting new members, amending operating agreement, selling the company, taking on debt over $X, changing business purpose, dissolving the LLC.
Buy-Sell Provisions (Transfer Restrictions)
What it does: Controls when and how members can sell their ownership. Prevents unwanted third parties from becoming members.
Must Include:
- Right of first refusal (existing members can buy first)
- Valuation method for member interest
- Permitted transfers (to family, trusts, etc.)
- Restrictions on transfers (need member approval)
- Drag-along and tag-along rights
What Happens If You Skip It:
Members can sell to anyone, including competitors. You might end up in business with someone you never agreed to work with. Valuation disputes when someone wants to exit. No process for buying out a departing member.
Common Valuation Methods:
- Multiple of EBITDA or revenue
- Book value of assets
- Independent third-party appraisal
- Formula based on trailing 12-month financials
Member Death, Disability, or Withdrawal
What it does: Plans for the inevitable: members leaving voluntarily or involuntarily.
Must Include:
- What triggers a buyout (death, disability, bankruptcy, withdrawal)
- Buyout price and payment terms
- Timeline for buyout completion
- Funding mechanism (life insurance, installments, etc.)
- Rights of remaining members vs. departing member's estate
What Happens If You Skip It:
A deceased member's interest passes to their heirs, who may have no business experience or interest in continuing. Disabled members retain full ownership with no path to exit. No clear mechanism to fund buyouts, creating cash flow crisis.
Smart Insurance Strategy:
Many LLCs maintain life insurance on key members, with the LLC or other members as beneficiaries. This provides instant liquidity for buyouts.
Deadlock Resolution Mechanism
What it does: Provides a way forward when members fundamentally disagree and can't reach consensus.
Must Include:
- Definition of deadlock situation
- Mediation requirement before legal action
- Arbitration clause (binding vs. non-binding)
- Buy-sell triggers in deadlock scenarios
- Shotgun clause or Russian roulette provision
What Happens If You Skip It:
LLC becomes paralyzed when 50/50 members disagree. Expensive litigation is the only option. Business operations grind to a halt. Customers and employees suffer. Value of the business plummets.
Shotgun Clause Example: "In the event of deadlock, any member may offer to buy all other members' interests at a specified price. The other members must either accept the offer or buy the offering member's interest at the same per-percentage price."
Indemnification and Liability Limitation
What it does: Protects members and managers from personal liability for business decisions made in good faith.
Must Include:
- Scope of indemnification (when LLC covers legal costs)
- Limitations (no protection for fraud, willful misconduct)
- Advancement of expenses for legal defense
- Insurance requirements (D&O insurance)
- Process for determining if indemnification applies
What Happens If You Skip It:
Members/managers face personal liability for business decisions. Fear of lawsuits prevents necessary risk-taking. Difficult to recruit quality managers. Personal assets are at risk in disputes.
Important Note:
Indemnification doesn't protect against fraud, intentional misconduct, or violations of law. It's for good-faith business decisions that turn out poorly.
Non-Compete and Non-Solicitation
What it does: Prevents members from competing with the LLC or poaching employees/customers.
Must Include:
- Geographic scope (must be reasonable)
- Time duration (typically 1-3 years post-exit)
- Specific prohibited activities
- Customer non-solicitation terms
- Employee non-solicitation terms
- Remedies for violation (injunction, damages)
What Happens If You Skip It:
Departing members immediately start competing businesses. They steal your best employees and customers. Years of business development lost overnight. No legal recourse to stop them.
Enforceability Warning:
Non-competes must be reasonable in scope, duration, and geography to be enforceable. Overly broad restrictions may be thrown out by courts. Consult local laws—some states (like California) heavily restrict non-competes.
Amendment Procedures
What it does: Establishes how the operating agreement itself can be modified.
Must Include:
- Voting threshold for amendments (supermajority recommended)
- Notice requirements before amendment votes
- Restrictions on amendments (e.g., can't reduce ownership without consent)
- Process for documenting amendments
- Provisions that require unanimous consent to change
What Happens If You Skip It:
Majority members can unilaterally change critical terms. Minority members have no protection. Disputes over whether changes are valid. Ambiguity about which version of agreement is controlling.
Example: "This Agreement may only be amended with approval of members holding at least 75% of ownership interests. Amendments affecting any member's ownership percentage or distribution rights require unanimous consent."
Dissolution and Winding Up
What it does: Defines when and how the LLC can be dissolved and how assets are distributed.
Must Include:
- Events triggering dissolution (vote, bankruptcy, member departure)
- Voting requirements to dissolve
- Process for winding up business
- Order of payment (creditors first, then members)
- Asset distribution formula
- Authority to sign dissolution documents
What Happens If You Skip It:
Confusion about when LLC should dissolve. Fights over asset distribution. Unclear who has authority to wind down operations. Potential personal liability for improper dissolution. Tax complications.
Standard Distribution Order:
- External creditors and lenders
- Member loans to the LLC
- Return of capital contributions
- Distribution of remaining assets per ownership %
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Additional Important Clauses to Consider
While the 10 above are non-negotiable, these additional clauses are highly recommended:
- Confidentiality: Protects trade secrets and proprietary information
- Intellectual Property Assignment: Ensures IP created for the business belongs to the LLC
- Books and Records: Member rights to inspect financial statements and records
- Fiscal Year and Accounting: Tax year, accounting method, financial reporting requirements
- Member Meetings: Annual meeting requirements, special meeting procedures
- Fiduciary Duties: Duties of loyalty and care owed by members/managers
- Banking and Contracts: Who can sign contracts, open accounts, incur debt
Common Mistakes When Drafting Operating Agreements
Copying a Template Without Customization
Generic templates don't reflect your unique situation. Every LLC is different—ownership structure, capital contributions, management style all vary. One-size-fits-all doesn't work.
Vague Language
"Members will split profits fairly" is meaningless. Be specific: "Member A receives 60%, Member B receives 40% of net profits calculated quarterly."
Ignoring State-Specific Requirements
LLC laws vary by state. Delaware has different rules than California or Texas. Ensure your agreement complies with your state's LLC statute.
No Dispute Resolution Mechanism
When partners disagree (and they will), you need a predetermined process. Mediation, arbitration, or buyout provisions prevent costly litigation.
Never Updating the Agreement
Your operating agreement should evolve as your business grows. Review annually and update when adding members, raising capital, or changing business model.
FAQ: Operating Agreement Clauses
What happens if my LLC doesn't have an operating agreement?
Without an operating agreement, your LLC will be governed by default state laws, which may not align with your intentions. This can lead to disputes, unclear decision-making authority, and difficulty handling member exits or business changes. While some states don't legally require an operating agreement, having one is critical for protecting all members.
Can I write my own operating agreement?
Yes, you can draft your own operating agreement using templates or AI tools, but it's highly recommended to have a business attorney review it. Critical clauses must be properly drafted to be enforceable and protect your interests. The cost of legal review ($500-2,000) is minimal compared to the cost of disputes later ($50,000+).
How often should I update my operating agreement?
Review your operating agreement at least annually and update it whenever there are significant business changes, such as: new members joining, members exiting, changes in ownership percentages, raising capital from investors, significant changes in business strategy or operations, or changes in state LLC laws.
Do single-member LLCs need operating agreements?
Yes! Even single-member LLCs benefit from operating agreements. They prove the LLC is separate from you personally (protecting limited liability), establish clear business procedures, provide guidance if you later add members, and demonstrate legitimacy to banks, investors, and partners. Many banks require an operating agreement to open a business account.
What's the difference between member-managed and manager-managed?
Member-managed: All members participate in day-to-day operations and decision-making (like a partnership). Best for small LLCs where all members are active. Manager-managed: Members appoint one or more managers to run operations, while members act as passive investors. Best for LLCs with passive investors or when only some members want operational control.
Can we amend our operating agreement after formation?
Yes, operating agreements can and should be amended as needed. Your agreement should specify the amendment process (typically requiring supermajority or unanimous member vote). All amendments should be documented in writing and signed by all members. Keep all historical versions on file for reference.
Final Thoughts
Your operating agreement is the foundation of your LLC. These 10 clauses aren't just legal formalities—they're the guardrails that prevent your business from careening off course when challenges arise. Every successful LLC has a comprehensive operating agreement; every failed partnership lawsuit features a missing or inadequate one.
Don't gamble with your business. Invest the time (or money) to create a proper operating agreement that includes all critical clauses. Your future self will thank you.
Remember:
The best time to create a comprehensive operating agreement is at formation. The second-best time is right now. Don't wait until disputes arise—by then it's too late.