Key Elements of an Operating Agreement
If you have an LLC, then you should have an operating agreement.
Here I break down the different elements of an operating agreement and why you need one.
How you manage your company can be decided by you, or it can default to the requirements of various laws. Either way, a set of rules will govern, so you might as well choose them. And if there is more than one “member” of the LLC, then an operating agreement is essential. In this article, we’ll give you an overview of the key parts of an operating agreement. Although we focus on an LLC operating agreement, many of the same terms and issues are applicable to partnership agreements and corporation bylaws.
Ownership Structure
An LLC’s “owners” are called members. A membership interest is the amount (usually in percentages) of the LLC that the member owns. This interest can also be expressed in a number of “units” or “shares” instead of a percentage. Although the membership interest usually reflects both the “economic interest” (share of profits) and the “management interest” (voting rights and authority to act on behalf of LLC), the operating agreement can separate the two so that the membership interest may not directly correlate to one of them.
An operating agreement can also create classes of membership interest. Different classes of interests can be established (like Class A and Class B), with each Class having different economic and/or management interests. This can be especially helpful if a company is looking for investors but does not want to give up control of the business.
Management
Without an operating agreement, the members/partners each have full authority to manage the business. For some, this may be fine. For others, it may best to designate one member as the manager and then figure out what kind of decisions have to be voted on by all the members.
Voting
The default rule is that members vote in proportion to their percentage interests. However, an operating agreement may change that, giving greater weight to the votes of some members, based on things like the amount of capital contributions or the value of each member’s capital account. The operating agreement may also limit voting rights based on the classes of membership interests created by the operating agreement. The operating agreement will identify what decisions require a vote of the members, who is entitled to vote on such decisions, and whether a majority, super-majority, or unanimous vote is required.
Distributions
Distributions are basically how the profits are paid out to the members. You can control how much of the profits can be distributed, when distributions are made, the priority of who gets paid, and how much each member gets paid. The default is that each member is paid out a share of the profits pro rata (based on his or her percent interest in the company). However, some members may earn “sweat equity” and be entitled to a greater percentage of the profits as compensation for the work. Or some members may have invested more money, but instead of increasing their ownership interest, they are entitled to have that extra investment paid off first before the profits are distributed to others.
Capital Contributions
Capital contributions are the amounts “contributed” to the business by each member. The capital can take on a number of forms, such as cash, property, or services. The capital contributions of each member are reflected in each member’s “capital account,” and includes the initial investment to fund the business, as well as any additional capital infusions that may have been made. The default is that the amount of a member’s capital contributions correlates to their percentage interest in the company. However, an operating agreement can change that.
An operating agreement can also specify whether additional contributions are voluntary or mandatory, as well as what happens in the event that some members voluntarily contribute more, and others don’t
Transferability of Interests
Transfers of interest are when a member wants to transfer his or interest (economic and/or management interests) to another party. The other party may be another member of the LLC or a third-party. These transfers can be both voluntary or involuntary, and can be triggered upon certain events, like death or retirement. Since members usually work closely together, the non-transferring members usually want a right of first refusal to purchase the shares that are going to be transferred or have veto power over who those shares can be transferred to. Even for a single member LLC, outlining automatic transfer upon death or disability can be a great help in succession planning for your business and for your estate.
An operating agreement can also detail how a member’s interests are to be valued for the purposes of a transfer or purchase and when a closing on an assignment or purchase must be completed. This helps avoid disputes down the road.
Limitation of Liability/Indemnification
These provisions of an operating agreement usually provide for a release of liability against the managers and/or members for any damages caused by actions lawfully taken on behalf of the LLC. They also usually require the LLC to pay for the defense and judgments for any claims brought against managers and/or members for any damages caused by actions lawfully taken on behalf of the LLC.
Confidentiality/Non-Compete
An operating agreement can include provisions that require the members to maintain confidentiality of information or documents provided by the LLC or other members, as well as prohibiting members from engaging in competition with the LLC or soliciting or usurping the LLC’s business opportunities, vendors, or employees, either personally or through another business.
Summary
These are only a few of the things that an operating agreement can address. Given the complexities of operating agreements, and the need to make sure they conform to the ways in which you actually want to manage your business, it is an opportunity to hire an attorney to help you get one in place for your LLC.
Disclaimer:
Information contained in this post is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem, and it should not be substituted for legal advice, which relies on a specific factual analysis. Moreover, the laws of each jurisdiction are different and are constantly changing. This information is not intended to create, and receipt of it does not constitute, an attorney-client relationship. If you have specific questions regarding a particular fact situation, we urge you to consult the with Michael H. Ansell, Esq., or other competent legal counsel.