Operating Agreement

An operating agreement is the internal governing document of a limited liability company (LLC) that defines the ownership structure, member rights and responsibilities, profit and loss distribution, decision-making authority, and procedures for major events like adding members, transferring interests, or dissolving the company. While the articles of organization filed with the state create the LLC, the operating agreement is the document that controls how it actually operates. For mortgage note investors, a properly drafted operating agreement is not a formality — it is a structural requirement for maintaining the liability protection that makes an LLC worth forming in the first place.

Why Every Note Investing LLC Needs One

The primary reason note investors form an LLC is to create a legal wall between business assets and personal assets. If a borrower files a lawsuit, if a regulatory action targets a loan, or if a title dispute arises, the LLC limits the claimant's reach to the assets held by the entity — protecting the investor's personal home, savings, and other investments.

However, courts can pierce the corporate veil and hold members personally liable if the LLC is not operated as a genuinely separate entity. One of the key factors courts examine is whether the LLC has a valid operating agreement and whether the members follow it. An LLC without an operating agreement — or one that exists on paper but is routinely ignored — is vulnerable to having its liability protection stripped away.

Even single-member LLCs should have an operating agreement. Many states do not legally require one for a single-member LLC, but the document reinforces the separation between the individual and the entity that is the entire point of the structure.

Key Provisions in a Note Investing Operating Agreement

Ownership and Capital Contributions

The operating agreement defines each member's ownership percentage and their initial capital contribution. For a single-member LLC, this is straightforward — one member owns 100%. For multi-member LLCs formed between partners or a joint venture group, the agreement specifies:

• Each member's percentage interest
• The amount and form (cash, assets, services) of each member's initial capital contribution
• Procedures and obligations for additional capital contributions
• Whether capital contributions earn a preferred return before profits are split

Profit and Loss Allocation

The agreement governs how profits and losses are distributed among members. In a simple two-member LLC, this might be a 50/50 split. In more complex arrangements — such as a structure where one partner provides capital and another provides deal-sourcing and management expertise — the allocation may be weighted or tiered.

Management and Decision-Making

The operating agreement establishes who has authority to make decisions on behalf of the LLC. There are two common structures:

• Member-managed — all members participate in management decisions. This is typical for small note investing LLCs where all members are actively involved in acquisitions, due diligence, and resolutions.
• Manager-managed — one or more designated managers have authority to act on behalf of the LLC, while other members are passive investors. This is common when one partner runs the note business and others contribute capital.

The agreement should specify which decisions require unanimous consent (selling the entire portfolio, taking on debt, admitting new members) versus which can be made by the managing member alone (purchasing individual notes, engaging a servicer, hiring vendors).

Transfer Restrictions

Note investing LLCs often include provisions that restrict members from freely transferring their ownership interests. Common restrictions include:

• Right of first refusal — existing members have the right to purchase a departing member's interest before it can be sold to an outside party
• Approval requirements — transfers require consent of the remaining members or a supermajority vote
• Prohibited transfers — certain transfers (to competitors, to minors, or to parties who do not meet accredited investor requirements) may be expressly prohibited

These provisions prevent unwanted third parties from becoming co-owners of the note portfolio.

Dissolution and Wind-Down

The operating agreement should define what happens if the LLC needs to dissolve — whether due to member disagreement, completion of the investment strategy, or other triggering events. Key provisions include the events that trigger dissolution, the process for liquidating the note portfolio, the order of priority for distributing proceeds (debts first, then capital contributions, then remaining profits), and the member or manager responsible for managing the wind-down.

Operating Agreement vs. Corporate Resolution

An operating agreement governs the ongoing operations of the LLC as a whole. A corporate resolution is a specific, one-time authorization for a particular action — such as authorizing a member to sign a loan purchase sale agreement or open a bank account. The operating agreement defines who has the authority to pass resolutions; the resolution itself is the exercise of that authority.

Common Mistakes to Avoid

Using a generic template without customization. Free operating agreement templates found online rarely address the specific needs of a note investing business — provisions for capital calls to fund foreclosure costs, procedures for handling non-performing loans that require additional investment, or protocols for managing loans held in a self-directed IRA alongside LLC-held assets.

Failing to update the agreement as the business evolves. An operating agreement drafted for a two-person LLC buying its first note may not serve the same business three years later when it holds fifty loans across ten states and has added a third partner.

Not following the agreement's own provisions. An operating agreement only protects the LLC's liability shield if the members actually follow it. If the agreement requires annual meetings and formal capital contribution records, those steps must be taken — not just documented on paper and ignored in practice.

Skipping the agreement entirely for a single-member LLC. Without an operating agreement, a single-member LLC has no documented governance structure, making it easier for a court to treat the entity as an alter ego of the individual and pierce the veil.