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Important Topics to Cover in an Operating Agreement

Posted by Ryan M. Newburn | Apr 30, 2021 | 0 Comments

Before addressing topics to cover in an operating agreement, you might wonder why you need one in the first place. In the absence of an operating agreement, state laws governing LLCs, usually some form of the Uniform Limited Liability Company Act ("ULLCA"), will automatically apply to your company and to any disputes that might arise.

Drafting your operating agreement allows you to outline the rules your company is bound to follow, as state law allows operating agreements to modify most provisions in an operating agreement. Also, courts will look at your operating agreement to determine compliance and what recourse the parties should take in the event of a dispute. Word to the wise, while some states do allow oral operating agreements, you should memorialize the agreement in writing to avoid any subsequent evidentiary problems.

How will your LLC be governed?

The first topic to cover in any operating agreement is governance. Who is going to run your LLC? Here, there are two choices: member-managed and manager-managed. In most states, if you fail to indicate which management scheme your LLC will adopt in the operating agreement, it will be assumed your LLC is member-managed. Also, you should be aware that many states require a member-managed or manager-managed designation in the company's articles of operation.

When to choose Member-Managed

Under a member-managed LLC, all members share responsibility for running the daily business, and all members are given a voice when making decisions. Generally, all members retain the ability to bind the LLC to contracts as well. This corporate governance approach works well for small businesses with limited resources that don't require a separate management level to operate. If you and your other LLC members wish to run your own business, then you should pick the member-managed structure. One drawback with this approach, discussed below, is that it exposes LLCs to creditors who obtain member's interests. Consensus on decisions might become hard to reach, and some members might not be adequately equipped to make management decisions.

When to choose Manager-Managed

On the other hand, under a manager-managed LLC, the members appoint one or more managers, who may or may not also be members, to operate the LLC. Only the managers can bind the LLC to contracts and partake in the daily operational decision-making of the business. A typical example when manager-managed LLCs prove advantageous is when some members only want to be passive investors in the business. Two other scenarios where the manager-managed structure could be preferred are: (1) when your business is too large or complex to permit sharing management control amongst many members; or (2) when some members do not possess adequate management skills. There is one other key benefit that manager-managed LLCs offer. When LLCs have "silent partners" that are not involved with daily operations, a manager-managed LLC is the better choice for liability exposure. A manager-managed LLC splits its members' economic and management rights, vesting the management rights in a manager. This prevents a silent partner's creditor from obtaining a member's management interest in the LLC and forcing specific action. A con under this approach is members must relinquish their management rights and daily control over the business.

Voting Rights

Voting rights and decisions is another critical topic an operating agreement must cover. First, you should determine how voting power is vested. In most states, voting power in LLCs is proportional to ownership percentage or a per capita basis. Alternatively, you can allocate all day-to-day operational decision-making to one person, a manager in a manager-managed LLC, for instance, or allocate voting power amongst many people.

Also, you should decide which decisions will only require a majority vote and which critical ones demand unanimous consent. The majority of states assume that a majority vote is sufficient for ordinary course decisions, the authority that you could vest in one or several people for administrative efficiency purposes. Some decisions that might require unanimous consent, as several states suggest, are amendments to the operating agreement, mergers, conversions, admission of new members, and other out-of-the-ordinary course decisions.

Equity Structure

Any operating agreement should also provide clear details on an LLC's equity structure. On a basic level, this means determining ownership and member interests. This might involve creating classes of membership interests that might give one class of members full voting or economic rights and another class partial rights.

One issue to resolve at the outset is what constitutes a contribution and how to handle member liability for contributions. Generally, a contribution is money to fund an LLC's startup expenses; however, your operating agreement can include property and services performed for the LLC as valid contributions.

Next, the operating agreement could detail how to resolve contribution problems. For example, could a member who is unwilling to continue performing services for the LLC give an equivalent monetary amount to the LLC instead. Also, the operating agreement can include a provision allowing the obligation to make contributions to be relieved by vote, one that several states suggest should be a unanimous one.

Profits, Losses, and Distributions

Your operating agreement should also outline how profits, losses, and distributions are handled. Most states, by default, mandate that an LLC's profits and losses are allocated to members based on a per capita basis. You should consider if it makes sense to deviate from this default rule based on your business situation. For instance, if some members contributed cash to the LLC and others only contributed services, you might allocate a more significant share of profits to the cash-contributing owners.

Most states also assume that distributions, how profits are actually handed out to members, are allocated on a per capita basis. You should decide when distributions are given to members and on what basis. Also, you might consider if your LLC will retain some of its profits for investing or capital expense purposes instead of distributing it to members.

Transfer Restrictions

Transfers are another necessary topic to cover. First, does your LLC want to allow member interests to be transferable in the first place? Perhaps you don't want the risk of dealing with outside parties. In that case, you can draft a provision in your operating agreement to prevent transfers of membership interests.

Almost all states allow membership interests to be transferred, so draft accordingly if you don't want vexatious transferees in your life. Second, if you do decide on allowing transferable interests, consider special provisions tailored to transferees. For example, precluding transferees from participating in the management of the company's activities prevents outside parties from getting a seat at the management table by buying out members.

Likewise, you might want to exclude transferees from accessing the company's confidential records or information. Also, it would be best if you addressed whether the transferor retains any rights as a member and the duties and obligations of a member.

Some other clauses that might be helpful to include in this section are:

  • Right of First Refusal: Requires a member who receives an offer for their membership interests from a third party offer that interest to other members before selling the interest to the third party.
  • Right of First Offer: Requires a member to first offer their membership interest for sale to members before offering it to a third party.
  • Veto/approval rights: Allow members to approve or veto membership transfers.
  • Tag along rights: Gives minority members in an LLC the right to participate on a pro-rata basis in any controlling member's sale of its membership interests.
  • Drag along rights: Gives majority members selling their membership interests to third parties the right to force other members to sell all or a portion of their membership interests to such third party.

Restrictive Covenants

Any well-drafted operating agreement should include a non-compete and non-solicitation clause. Remember when drafting a non-compete clause that the clause must be reasonable in scope, duration, geographic area, and type of activity restricted to be valid. This will prevent disassociated members from directly competing with your LLC. Generally, the non-solicitation clause should be of shorter duration and only cover clients the disassociated member actually solicited with while an LLC member. This prevents the disassociated member from pillaging your LLC's employees and clients.

Recordkeeping

Recordkeeping is another issue the operating agreement should address. Consult your state statutory Business Code for the basics because virtually all states impose recordkeeping requirements on LLCs. Some of these requirements include: (1) a list of each member's name; (2) the amount of cash, property, or services contributed by each member; (3) the articles of organization and all amendments; (4) the operating agreement and all amendments; and (5) recent federal, state and local tax returns. You might wish to include provisions for recording LLC meeting minutes and votes.

It would help if you detailed when members can access and copy the LLC records and the conditions for furnishing information related to the LLC to members on-demand. For instance, your LLC operating agreement could provide that inspection of records must occur during regular working hours.

How Will Your LLC Be Taxed?

Your operating agreement should also resolve how the LLC will be taxed. By default, an LLC is taxed as a pass-through entity, meaning that the LLC pays no entity-level tax when it earns income; only the members pay tax on their income. Conversely, the operating agreement can elect for the LLC to be taxed twice like corporations. In this context, profit and loss allocation come back into the picture again as a tax accounting tool. LLCs use a member's capital account. The profits and deduction levied against it to allocate tax items amongst members, ultimately identifying which members are responsible for the LLC taxable income.

On the other hand, distributions are generally treated as a non-taxable return of the member's investment in the company because the members have already paid their fair share of tax on the company's earnings. An LLC will allocate income to its members every year, and those members must report the LLC profits on their tax return, even if the LLC makes no distributions to the members. Keep in mind this problem of phantom income, where members have to pay income tax even though they have not received cash to pay the taxes when drafting the operating agreement. In response, consider drafting provisions making special allocations that distribute income tax disproportionally among members so the tax is assessed against members who can pay.

Dissolution

Finally, your operating agreement has to address how it all ends: Dissolution. Your operating agreement should outline events that cause dissolution, for instance, if you wish that the death of a particular member should cause the dissolution of the LLC or that the LLC dissolve on a specific future date. Also, the operating agreement could provide that dissolution occurs on a unanimous vote, as most states follow, or only on a majority vote of the members.

Similarly, the operating agreement should decide whether members can rescind dissolution and what type of vote would be necessary for such action. The operating agreement should limit the ability of members to bind the LLC during dissolution. This prevents the member from making the LLC liable to creditors for deals entered into by members when the LLC's financial resources are stretched thin.

Any member who does enter into an agreement on behalf of the LLC should be required to reimburse the LLC for any damages, with any limitation on the amount of damages included in the operating agreement. The operating agreement should include any modifications to the statutory default of priority of post-dissolution distributions, as in what happens to what is left over after creditors have been paid. Finally, consider requiring a full accounting of the dissolution process to all members, with the cost of the accounting allocated amongst the members. This can be particularly important when creditors or other third parties are assignees of members' interests.

Contact An Experienced Law Firm

If you just formed an LLC, or are looking to do so, contact an experienced Newburn Law attorney today to learn more about what you should include in your operating agreement and what issues you might initially be overlooking.

About the Author

Ryan M. Newburn

Ryan Newburn is a business and legal expert trusted by Executive Teams and Boards of Directors to apply sound business principals to solve legal and financial problems. Ryan's practice focuses on mergers and acquisitions, financings, corporate formations and corporate governance in a broad range of industries including energy, distribution services, healthcare, medical devices, and technology. Leveraging his formal business training and years of practical experience, including as an executive at public and private companies, Ryan has advised hundreds of companies in dozens of industries of unique legal and financial issues.

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