LLC Operating Agreements
§ 8.1Operating 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. Topics should include—
•division of the members’ ownership interests;
•initial and potentially future capital contributions;
•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;
•events of member/manager default and company recourse;
•buy-sell agreement to maintain company control;
•restrictions on transferability of ownership interest; and
•dispute resolution.
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.
§ 8.2Consequences 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, and any other personal obligations of the members.
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, 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.
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.