LP / LLC Operating Agreement Review Guide

What it is

An operating agreement (for LLCs) or limited partnership agreement (for LPs) is the contract among members/partners that governs the entity. It dictates ownership, decision-making, distributions, transfers, and dissolution. Critically: it overrides almost all default state law.

Operating agreements come in two main flavors: simple (a few founders, basic governance) and complex (institutional investors, multiple classes of equity, sophisticated waterfalls). The same form differs by orders of magnitude in length.

Heavily fact-specific. A perfectly-drafted agreement for a real-estate fund is wrong for a SaaS startup, which is wrong for a holding company, which is wrong for a family office. The 9 clauses below are universal; the specifics need to match the use case.

Common clauses to check

1. [ 01 ]

   Capital contributions & calls

   What members put in initially and the rules for contributing more later.

   What to look for

   • Initial contributions clearly stated — cash amount, property at value, services contributions documented.
   • Capital call mechanism — voluntary, mandatory, or upon majority vote.
   • Default penalties — dilution, forfeiture, loan-and-charge.
   • Anti-dilution and pro-rata participation rights.

   Red flags

   • Mandatory capital calls without limit or notice.
   • Default-and-forfeit penalties without right to cure.
   • Dilution at unfair valuations on default.
2. [ 02 ]

   Allocations vs. distributions

   Allocations determine tax consequences (who pays tax on what); distributions determine cash flow (who gets paid).

   What to look for

   • Allocation rules consistent with substantial economic effect (tax law requirement).
   • Tax distribution provisions to cover members' tax liability on phantom income.
   • Distribution waterfall — typical structure: return of capital, preferred return, catch-up, profit split.
   • Special allocations for tax purposes (depreciation, deductions).

   Red flags

   • Allocations without substantial economic effect — at risk of being recharacterized by IRS.
   • Discretionary distributions without minimum standards.
   • Mismatch between allocations and distributions creating phantom income with no cash to pay tax.
3. [ 03 ]

   Manager / GP authority & restrictions

   Who runs the show and what they can do without member/LP consent.

   What to look for

   • Manager-managed vs. member-managed clarity.
   • List of major decisions requiring consent (sale of substantial assets, dissolution, amendment, admission of new members).
   • Day-to-day authority delegated to manager.
   • Removal of manager — for-cause and without-cause.
   • Indemnification of manager.

   Red flags

   • Manager can take any action without restriction.
   • Manager removable only for narrow cause definitions.
   • Indemnification of manager broader than fiduciary duty allows.
4. [ 04 ]

   Distribution waterfall

   How cash flows out. Most contentious in investment funds and real estate vehicles.

   What to look for

   • Tier structure: return of capital, preferred return (often 8% IRR), catch-up to GP, then profit split (often 80/20).
   • Who in the chain — capital partner, then carried interest holder.
   • Whether each tier is calculated on cumulative or incremental basis.
   • Clawback provisions if final distributions over-pay GP.

   Red flags

   • Convoluted waterfall language that produces different numbers in practice than parties expect.
   • No clawback — GP keeps over-distributed amounts.
   • Catch-up at 100% (GP gets every dollar above preferred until catch-up complete) — aggressive but standard.
5. [ 05 ]

   Transfer restrictions

   Whether members can sell or transfer their interests.

   What to look for

   • Right of First Refusal (ROFR) for the entity or other members.
   • Permitted transfers (estate planning, related entities).
   • Manager consent requirements.
   • Tag-along rights.

   Red flags

   • No transfer rights at all (illiquidity by design but with no exit valve).
   • Manager consent at "sole discretion" without good faith standard.
   • ROFR with extended consideration windows.
6. [ 06 ]

   Drag-along & tag-along rights

   Drag-along: majority can force minority to sell on majority's terms. Tag-along: minority can force participation when majority sells.

   What to look for

   • Drag-along threshold (usually 50%+).
   • Drag-along terms must be the same for all members.
   • Tag-along rights symmetric to drag-along.
   • Minimum-price floor on drag-along (often required for fairness).

   Red flags

   • Drag-along at lower threshold than majority (e.g., 30%).
   • Drag-along forces minority to sign restrictive covenants (non-compete, etc.).
   • Tag-along carve-outs that swallow the rule.
7. [ 07 ]

   Buy-sell on triggering events

   Mandatory buy-out triggered by death, disability, bankruptcy, divorce, or termination of employment.

   What to look for

   • Specific triggers listed.
   • Valuation methodology (formula, appraisal, prior agreement).
   • Payment terms (cash, installment, interest rate).
   • Insurance funding for buy-out (key person, life).
   • Treatment of voting rights of departing member.

   Red flags

   • Forced buy-out at distressed valuations.
   • Long installment payouts (10+ years) at low interest rates.
   • Discretionary buy-out by other members rather than mandatory.
8. [ 08 ]

   Fiduciary duties

   Duties of loyalty and care among members and managers. Default state law applies unless modified.

   What to look for

   • Specific identification of fiduciary duties (loyalty, care).
   • Permitted modifications (Delaware allows substantial elimination).
   • Conflicts of interest disclosure and approval procedures.
   • Right to engage in competing businesses.

   Red flags

   • Complete elimination of fiduciary duties — sometimes legally allowed but ethically suspect.
   • Asymmetric duties (members owe duties; manager doesn't).
   • Pre-approval of broad categories of self-dealing.
9. [ 09 ]

   Dissolution & winding up

   How the entity ends and how its assets get distributed.

   What to look for

   • Dissolution triggers (term expiration, vote, sale).
   • Winding-up procedure and authority.
   • Final distribution waterfall on liquidation.
   • Continuing obligations post-dissolution.

   Red flags

   • Dissolution by manager alone with no member vote.
   • Distribution priorities that strip economic interest from minority members.
   • Indefinite winding-up periods.

Other watchouts

• Series LLC structures — multiple series with separate liability.
• Subsequent classes of membership interests (preferred, common, profits interests).
• Profits interests for service providers — granted at "safe harbor" valuation per Rev. Proc. 93-27.
• Tax matters partner / partnership representative for new BBA audit rules.
• Books and records access — for members, ex-members.
• Confidentiality obligations.
• Information rights (financial statements, K-1s).
• Amendment procedure — what supermajority is required.
• Choice of law (Delaware is dominant for sophisticated agreements).
• Specific ERISA and securities-law representations.

Frequently asked questions

Do I need an operating agreement for my LLC?

Strictly, most states don't require one. Practically, yes — without it, your state's default LLC law applies, which is usually wrong for almost every LLC. The default rules typically allocate profits equally regardless of contribution, give every member equal voting rights, and don't address transfers, dissolution, or buyouts.

What's the difference between an LLC and a limited partnership?

Both are flow-through taxation entities with limited liability. LLCs have members (who can be active managers); LPs have general partners (active, full liability) and limited partners (passive, limited liability). LLCs are more flexible in governance; LPs are more familiar to investment-fund investors. Modern fund structures sometimes use LLCs taxed as partnerships, blurring the distinction.

What is a distribution waterfall?

A multi-tier rule for how distributions get split. Standard private equity / real estate waterfall: (1) return of all capital contributions, (2) preferred return (e.g., 8% IRR), (3) GP catch-up, (4) split of remainder (e.g., 80/20). Each tier defines who gets what before the next tier kicks in. The complexity allows GPs to align incentives with LPs.

Can fiduciary duties be eliminated?

In some states, mostly yes. Delaware famously allows almost complete elimination of fiduciary duties in LLC operating agreements, with the exception of the implied covenant of good faith and fair dealing. Other states are stricter. Eliminating duties is sometimes appropriate (sophisticated investors negotiating arms-length); often it's a red flag.

What's a drag-along right?

The right of majority equity holders to force minority equity holders to sell on the majority's terms in a sale of the company. Critical for buyers who want to acquire 100%; without drag, a single recalcitrant minority holder can block deals. Reciprocal tag-along rights protect minority by ensuring they can participate at majority's terms.