What Is The Difference Between an Operating Agreement and Bylaws?
When entrepreneurs and people with a business vision decide to form a company, figuring out which type of entity and accompanying legal documents can feel prohibitive. Two of the more confusing are bylaws and operating agreements. Because they seem so similar in nature, professionals end up overspending their limited resources on attorney fees. But by understanding the difference between an operating agreement and bylaws, you can make an informed decision about whether to draft them yourself or outsource them. These are key documents with a direct impact on your new business, and getting familiar with them as well as other essential LLC facts is key to success.
What Is An Operating Agreement?
In many ways, an operating agreement fills in the blanks of a limited liability company (LLC). When businesses are formed, the members file articles of incorporation that provide definitions of the corporate structure and functions. An operating agreement is drafted by the company’s owners to outline how financial and other decisions are made.
Although crafting and agreeing to an operating agreement is only mandatory in a handful of states, it remains a crucial document. Should the owners of an organization fail to create a specific operating agreement, decision-making powers may not be clear. When disagreements arise between the members, the state’s rule might govern corporate actions. That’s why business leaders typically include the following in their operating agreements.
- How ownership is structured
- Each person’s percentage of ownership
- Expected capital contributions
- Degree and manner of profit sharing
- Voting rights and procedures
- How losses and liabilities are distributed
- Structure of the management team
- Decision-making process
What all of these components have in common is that they articulate practices that might otherwise result in disagreements. Dissent among owners can prove toxic to an LLC. However, an agreed-upon set of rules helps the parties avoid internal conflict.
What Are Bylaws?
Unlike an operating agreement, the majority of states require companies to either file or memorialize bylaws. This official document is agreed upon by the members and serves as an internal guide outlining how the organization runs. A corporate board typically adopts bylaws as a way to summarize the fundamental practices and procedures of the organization. The legally binding document also speaks to decision-making authority.
In many ways, bylaws echo the corporate sentiments one might find in an operating agreement. That’s largely because both are efforts to streamline internal processes and assign rights and obligations. If you are forming a corporation, these are basic issues to address in your bylaws.
- Purpose of the organization
- Structure of the Board of Directors
- Number of parties serving on the Board of Directors
- Procedures for adding and removing board members
- Procedures governing committee appointments
- How dividends are allocated
- Methods for amending bylaws
Along with minimizing internal discord, well-crafted bylaws provide stability. The practices and procedures established in the document provide continuity as members exit the company and new ones enter. While an operating agreement and bylaws appear similar on the surface, there are some crucial differences to consider.
Difference Between an Operating Agreement and Bylaws
Perhaps the most straightforward way to distinguish an operating agreement from bylaws involves the type of company being formed. When creating an LLC or corporation, states require an initial public document. For corporate entities, this is typically called the “Articles of Incorporation.” Should you decide to start an LLC, states usually require owners to file “Articles of Organization.”
After these charter documents are approved by the state where you plan to do business, a secondary legal document governs internal business practices. If you filed for an LLC, an operating agreement is considered the best option. Corporations, on the other hand, almost always draft bylaws. Aside from each generally applying to a different company structure, these rank among the chief differences.
- Authorship: An operating agreement is typically drafted by LLC owners. By contrast, bylaws are crafted and adopted by a corporation’s Board of Directors.
- Parties: While both documents are legally binding, LLC owners are usually named in the operating agreement. Because bylaws govern corporations with changing members, their shareholders and decision-makers are not necessarily named.
- Signatories: When bylaws are executed and adopted by a corporation, an officer or designated parties can sign off instead of shareholders. All the members of an LLC are usually required to sign an operating agreement.
- Legally Bound: An operating agreement lists the LLC members and, thus, makes them legally accountable. Bylaws do not specifically name the parties. Therefore, they may not necessarily be directly bound to it, from a legal perspective.
- Financial Directives: Bylaws do not usually address financial issues such as taxes, profit, and loss, or capital contributions. An operating agreement addresses these and other issues that have financial implications.
Although the vast majority of states task corporations with crafting and adopting bylaws, only a handful require LLCs to formalize an operating agreement. When launching a business, it’s essential to determine your state’s requirements and how its laws impact your internal legal documents.
How States Treat Bylaws and Operating Agreements
Of the 50 states and the District of Columbia, approximately 15 do not require corporations to implement legally binding bylaws. Of those, California requires entities to have an operating agreement. Popular states to open businesses such as Florida and Texas appear flexible about operating agreements, this, coupled with other benefits for SMBs, makes Florida a popular destination to open an LLC in. Tax-heavy states such as New York mandate bylaws and operating agreements to coincide with the business type. For the purposes of better understanding what to expect when forming an LLC, consider how the following state laws work.
How California Addresses Operating Agreements
Based on California’s Corporation Code §17050, every California LLC is required to have an LLC Operating Agreement. Multi-member LLCs typically file documents up to 70 pages long and small outfits usually require 15 pages to provide all the pertinent information. This includes whether the organization is run by a manager or the members, financing, record-keeping, and individual rights and obligations, among others.
How Texas Addresses Operating Agreements
The Lone Star State works diligently to create a business-friendly environment. Part of those efforts involves flexibility in terms of legal documents. Texas does not mandate an LLC to create an operating agreement. However, those in the business landscape generally agree it’s prudent to implement one. The key reason industry leaders cite in favor of an operating agreement involves liability. Members could be held personally liable for losses caused by the LLC without an operating agreement.
How Florida Handles Operating Agreements
Like Texas, the Sunshine State possesses among the most attractive and business-friendly landscapes in the U.S. The flexibility it affords organizations in terms of internal operating agreements can be something of a double-edged sword. While LLCs are not required to craft operating agreements, the state has a default position. In the absence of a legal document crafted by the members, LLCs can be bound by the generic rules established by the state. While Florida LLC rules are primarily in place for the purposes of dispute resolution, it’s in the member’s best interest to have a customized operating agreement that addresses their unique organizational needs.
Do You Need A Lawyer To Create an Operating Agreement
There was a time when a startup desperately needed an attorney to handle its legal documents. But living in the digital information age has made drafting accurate operating agreements and forming LLCs easier than ever before.
Because many LLCs are relatively modest operations with tight budgets, it’s worth exploring online templates and platforms that help entrepreneurs launch businesses. These can be particularly helpful in states such as Florida that do not require you to file a copy of your operating agreement with the state.
This article has been published in accordance with Socialnomics’ disclosure policy.