When setting up a new LLC, it's fairly easy to properly prepare and file the articles of organization to get the company formed. The real legal challenge is in defining how your business will function and operate. That's the purpose of an LLC operating agreement. The operating agreement sets forth the internal rules for governing a limited liability company, including the respective rights, obligations, and duties of its members.
An operating agreement is a vital component of an LLC, and its content should be carefully tailored by the owners when the business is established. There is no such thing as a “one size fits all.” Every LLC is different, and the operating agreement should reflect the unique goals, business plan, and culture of the company and its members.
Here are four important questions to think about when constructing your company's operating agreement:
1. Why Is an Operating Agreement Important?
If your company does not have an operating agreement, the internal structure of your LLC is governed, by default, according to your state's version of the Limited Liability Company Act. For example, provisions of the Maryland Code provide, in general terms, that members have a percentage vote in decision making equal to that member's percentage ownership in the company (which is equal to the percentage that member invested). However, this approach may not be the best one for your company. You need to think about which decision-making structure would be the most beneficial to your company.
2. Who Will Make the Day-To-Day Business Decisions?
Many states' statutory provisions, as well as most operating agreement forms, provide that each member's voting power be weighted in proportion to his or her percentage of ownership. It is set up this way because it seems fair.
However, certain businesses may have different needs. Consider the hypothetical business partnership of Abe and Abigail. Abe and Abby have an innovative idea for a new smartphone application and decide to pool their talents and form an LLC. Abe has a large sum of money to invest but little business knowledge. Abby's finances are tight because she just completed her master's degree in computer science.
Abe provides 80% of startup capital and Abby, with her technology background, will make the day-to-day decisions. Without an operating agreement specifying this arrangement, Abe would most likely be authorized to make all of the business decisions because he invested the most money.
If Abby wants to use her expertise to run the business, they should consider drafting an operating agreement that either provides one vote per person, without regard to the percentage interest held or vest all decision-making authority in Abby. This way, it would be clear that Abe is an equity investor and Abby is the business manager (regardless of their respective capital investments).
Typically, when two people go into business and form an LLC, both want equal decision-making power. In this situation, it's prudent to consider what should happen when two members with equal voting power disagree.
Suppose Abe and Abby disagree about whether to rent a car to drive to a smartphone conference. With no operating agreement in place, or with the typical generic form, the odds are that neither has the authority to use the company's credit card if they cannot agree on it. T
o prevent this situation, Abe and Abby may consider adding a “deadlock provision” that covers how a “tiebreaker” is reached. Providing for a deadlock provision before it is needed enables members to keep business relations intact while also avoiding costly litigation.
3. What If a Member Wants to Sell Some or All of His or Her Interest?
When business is booming, members often seek to sell some or all of their interest in the LLC at a profit.
Often, nonspecific operating agreements allow members to transfer their interest in the LLC without restriction. This is good for the member who wants to sell, but it could leave the remaining members with a partner they don't care to deal with, or have never met. To address this issue, there are several options business owners can consider.
One is to draft the operating agreement to restrict the transfer of units unless the members holding a certain percentage of the non selling units approve. However, in that case, if the members do not agree, the member that wants to sell could not do so.
Another option is to include a standard right of first refusal clause. Under the typical right of first refusal, a member who receives an offer to buy their interest in the company by a third-party is obligated to offer the same membership interests to the other members or to the company as a whole on the same terms.
An advantage of this approach is that the members can prevent bringing an unknown person into the company, which may be important for companies that offer highly specialized services. However, a disadvantage is that the company may not have the finances to buy the selling member's interest.
4. What Issues Come Into Play When Members Want to Part Ways?
Perhaps the most important thing to consider is what will happen if members decide it is time to part ways. Addressing this issue is very business-specific because there is no perfect exit strategy. One approach is to state in the operating agreement that no member has the ability to withdraw without the unanimous consent of the other members.
An upside to this strategy is that the only way it can be negated is through a judicial dissolution of the entire company. This drastic outcome usually encourages members to negotiate. A potential downside, however, is that a member who feels misled may choose to litigate in hopes of pressuring resistant members to approve his exit, and this can be expensive and time-consuming.
Another option is to include a “put option” in the operating agreement. A put option allows a member to withdraw from the company and receive a payment (usually) equal to the then fair market value of the exiting member's interest.
The upside to this approach is that it seems the fairest. However, this may not be prudent if, for example, the company is a service-based business because the reduction of human capital caused by the member's exit impedes the LLC's ability to increase cash flow to finance a buyout.
In contrast to the above all-or-nothing strategies, an operating agreement may provide for a “go find a buyer” approach. This involves relaxing any transfer restrictions in the operating agreement, subject to the company's (or another member's) right of first refusal.
Under this approach, if a member wants to leave, that member would have to find a third-party to buy them out. A downside is that a member wanting to exit may not be able to find a buyer, especially if the company is losing money. On the upside, if the member does find a buyer, the company (or another member) has the option of purchasing the selling member's equity. This would allow the 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.
As all these examples illustrate, operating agreements are meant to reflect the preferences of the members. It is therefore important for business partners to consider these situations before the need arises.