A limited liability company (LLC) operating agreement is similar to corporate bylaws in that both types of documents define the terms of how your business will function. The operating agreement sets forth the internal rules for governing a limited liability company, including the respective rights, obligations and duties of its members. When forming your business, an operating agreement should be carefully tailored to reflect the owner’s unique goals, business plan and culture of the company and its members. Below are four important questions to consider when drafting your company’s operating agreement:
1. Why do I need an operating agreement?
An operating agreement serves as an important means of defining the decision-making structure that will dictate how your company is run. Having an operating agreement in place for your LLC can act as a line of protection that guards the status of your limited personal liability for your business’ dealings while also preventing any misunderstandings between company owners.
If your company does not have an operating agreement, the guidelines governing the internal structure of your LLC defaults to your state’s version of the Limited Liability Company Act. The guidelines listed in each state’s version of the LLC Act may not be the best approach for your company, and tailoring an operating agreement specific to your company’s needs may be a better fit for your business.
2. Who will make daily business decisions?
Many states’ statutory provisions, as well as most operating agreements, provide that each member’s voting power be weighted proportionally to his or her percentage of ownership. While this framework may seem “fair,” each business has different needs. For example, while certain members of a company may have more to invest in the operation, others might have more industry knowledge or expertise within the business. In this situation, it might be best to allow individuals with more industry know-how to make daily business decisions or allow them greater voting power.
Additionally, it is especially important for businesses to outline procedural requirements should a business decision be tied or unresolved. Typically, when two people go into business with each other and form an LLC, both may be given equal decision-making power. If two individuals with equal voting power disagree, a “deadlock provision” can cover how a “tiebreaker” is reached.
For example, if the company prohibits the use of company money from being spent without unanimous approval between two owners, business activity may be halted if the owners cannot agree with each other. Preparing a deadlock provision in a business’ operating agreement can ensure that if or when it is needed, business relations can be kept in tact while also avoiding the cost of litigation.
3. What if a member wants to sell some or all of his or her interest?
If your business is doing well, members might look to sell some or all of their interest in the LCC at a profit. Nonspecific operating agreements usually allow members to transfer their interest in the LLC without restriction. This is good for a member who wants to sell, but it might leave remaining members with a new partner that they don’t care do deal with or have never met. There are several options a business owner can pursue to address this potential problem. One is to draft the operating agreement in such a way as to restrict the transfer of units unless the members holding a certain percentage of non-selling units approve, which may restrict a member from selling.
Another option is to include a standard right of refusal clause. Under a typical right of first refusal, a member who receives an offer by a third-party to buy their interest in the company is obligated to offer the same membership interests to the other members or to the company as a whole on the same, exact terms. This option allows members to prevent bringing an unknown person into the company, which can be important for companies offering highly specialized services. The company, however, may not have the finances to buy the selling member’s interest.
4. What happens when a member wants to leave?
Addressing the issue of members leaving the company should be specific to your business. One approach is to state in the operating agreement that no member can withdraw from the company without the unanimous consent of the other members. The only way that this strategy can be negated is through judicial dissolution of the entire company. This drastic outcome usually encourages members to negotiate. On the downside, however, the member who wishes to exit might choose to litigate in hopes of pressuring resistant members to approve his exit, which can be expensive and time-consuming.
Another option is to include a “put option” in your operating agreement. A put option allows a member to withdraw from the company and receive payment typically equivalent to the then-fair market value of the exiting member’s interest. This approach seems the most fair; however, it may not be prudent if the company is a service-based business because the reduction in human capital as a result of a member’s exit might impede on the LLC’s ability to increase cash flow to finance a buyout.
In contrast to the above options, an operating agreement may use a “go find a buyer” approach. This approach involves relaxing any transfer restrictions in the operating agreement, subject to the company’s (or another member’s) right of first refusal. If a member wants to leave, that member would have to find a third-party to buy them out; however, if that member does not find a buyer, the company (or another member) has the option of purchasing the selling member’s equity. This approach allows current members to decide if it is wise for the company to let the third-party buyer join the business, while also providing the exiting member with some value for their interest.
Terms to Include in LLC Operating Agreements:
Each LLC operating agreement will vary from company to company, but there are a few essential terms covered in a majority of operating agreements. These terms include:
- A breakdown of the ownership percentage of each member
- The rights and responsibilities of each member
- A detailed plan showing how losses and profits will be distributed
- The voting rights of members
- A management plan for the business
- Rules for meetings and voting
- Buyout or buy-sell rules that govern a member’s sale of interest, or a member’s death or disability.
These are all significant factors to consider when drafting an operating agreement. The basic purpose of an operating agreement is to reflect the preferences of the owner(s) and company members on how the business should be run. It is therefore important for business partners to consider any potential pitfalls or conflicts regarding company management before the need arises.