Chapter 10 

LLC Operating Agreements

§ 10.1Operating Agreements Overview

Aside from the certificate of formation, the operating agreement (or company agreement) is the primary governing document of an LLC. The operating agreement, which is not publicly filed, covers much more material than the certif­icate of formation.

The purpose of the operating agreement is to govern the relations among members, managers, and officers of the company, assignees of mem­bership interests in the company, and the com­pany itself, as well as other internal affairs of the company. Without an operating agreement, the LLC is bound solely by the Texas Business Organizations Code (TBOC), which may or may not be advantageous for the given situation.

An operating agreement should cover the fol­lowing topics:

•division of the members’ ownership inter­ests;

•initial and potentially future capital contri­butions;

•allocation of profits and losses, and manda­tory or permissive distributions;

•accounting and taxation matters, including any representatives to the IRS;

•management roles, restrictions, and proce­dures;

•member voting rights and procedures;

•roles and rights of future additional mem­bers;

•limitations on personal liability, excul­pation, and indemnity of members and managers;

•events of member/manager default and company recourse;

•buy-sell agreement to maintain company control;

•restrictions on transferability of ownership interest;

•dispute resolution;

•events requiring the winding up or termina­tion of the entity; and

•procedures for winding up the company, liquidation of assets, and final distribution to members.

It is recommended that an operating agreement tailored to the needs of the individual business be drafted by a qualified attorney. A limited lia­bility company may, by agreement, modify the standard rules set forth in the TBOC, with the exception of certain non-waivable provisions described more particularly in TBOC section 101.054. To the extent that the company agree­ment of a limited liability company does not otherwise provide, the provisions of the TBOC applicable to a limited liability company govern the internal affairs of the company.

PRACTICE TIP:      When possible, ownership interests should not be evenly divided among the members. New business owners will often request even apportionment; however, this can easily lead to standstills on important decisions. It's better for members to have a conversation at formation regarding majority vote on certain matters. Additionally, if the majority interest holder is a woman or ethnic minority, the com­pany will be eligible for contract preference with many local government entities.

PRACTICE TIP:      As with all contracts, an effective operating agreement requires that the parties think through all practical scenarios and address how each will be handled. For multi­member LLCs, the members may obtain inde­pendent legal and financial advice to decide how best to negotiate the agreement. The attor­ney drafting the operating agreement should not give advice on competing interests. However, the drafter can provide a list of topics for the par­ties to discuss and prepare the document based on their agreement.

§ 10.2Consequences of Not Having Proper Operating Agreement

Operating agreements should be carefully tai­lored to fit the individual company’s needs. As with any contract, templates can be a helpful starting point but should be customized for each point that applies to the LLC and its members. Without a properly drafted operating agreement, LLCs are potentially subjecting themselves to—

•audit troubles due to lack of evidence of company structure, tax questions, and other matters;

•lengthy and costly litigation between the company and its members or among the members themselves;

•potentially co-owning a business with an adverse party, such as a former spouse or an executor of a member’s estate; and

•violating securities laws.

PRACTICE TIP:      In addition to having an oper­ating agreement, multimember LLCs may need a partnership agreement for matters pertaining to the individual members. This can include defined company roles, a buy-sell agreement, a noncompete clause, a nonsolicitation clause, a confidentiality clause, and any other personal obligations of the members.

§ 10.3Management Roles

LLCs may be member-managed (managed by its constituent members) or manager-managed (managed by an appointed manager, which can be an individual or an entity). The operating agreement should define manager authority and restrictions, and actions that require the consent of the members (and the level of consent required), which must be customized to the par­ticular company, including its size, operational needs, and members’ needs. Managers typically handle most of a company’s operational busi­ness, while members have input on larger struc­tural matters such as admission of new members and dissolution of the company. Any manage­ment meeting frequency and procedural require­ments should be defined, as well as any alternates or replacement triggers and proce­dures.

§ 10.4Buy-Sell Agreements

Buy-sell provisions may exist as a stand-alone contract or may be included as part of a larger operating or partnership agreement. These pro­visions are crucial for maintaining company control when members voluntarily or involun­tarily transfer their ownership interests. An involuntary transfer can occur, for example, upon a member’s incapacitation, death, or divorce or by court order. For a company to have recourse in the event of an involuntary transfer, buy-sell provisions should include a procedure for members and the company to repurchase transferred interests from implicated transferees (for example, a member’s former spouse or the executor of member’s estate).

Voluntary transfers occur when members sell their interests in the company. The company should have a clear process to repurchase mem­bers’ interests before they can be sold to third parties. If these matters are not addressed ahead of time, the remaining owners may be compro­mised into the scenario of running a company with an adverse party and adverse legal repre­sentatives.

PRACTICE TIP:      To minimize disputes, the operating agreement, or buy-sell agreement, should include a clear standard for determining the fair value of members’ interests.