Limited liability corporations (LLCs) are a popular choice of legal entity for new companies because they combine some of the benefits of both corporations and partnerships. While not required in every state, having an LLC operating agreement is highly recommended to prevent future conflicts between its members. After all, an agreement is most often reviewed when there is a disagreement. Having a well-crafted operating agreement in place can help a business focus its resources on growth and not on resolving inevitable disagreements.
An operating agreement outlines the structure and operation of the LLC. It serves as a contract governing how the LLC will be run and the terms of the business arrangement among its members.
What Are Key Provisions in an Operating Agreement?
An operating agreement should specify how the LLC is managed, voting requirements, decision-making procedures, how new members may be admitted, restrictions on transferring and selling interests, splitting of profits and dispute resolution mechanisms. In addition, the agreement should discuss the following:
- Members are the shareholders of LLCs. Generally, state rules govern who can be a member of an LLC. In most states, including New York, members can include individuals, corporations, other LLCs and foreign investors. Generally, LLCs can be structured as single-member LLCs (which are LLCs with only one owner) but more commonly, LLCs have multiple members. Operating agreements are especially important for multiple-member LLCs.
- Initial capital contributions. The agreement should list each member’s capital contributions to the business. Capital contributions can consist of cash, assets or services contributed to the LLC by a member. Assets can be tangible assets such as real property or equipment or intangible assets such as intellectual property.
- Additional capital contributions. The company may need more money as time passes. As a result, the LLC operating agreement should include provisions governing how members can make additional capital contributions at specified times. This can take the form of mandatory additional capital contributions or optional additional capital contributions. A capital call may also be issued for members to make contributions to cover urgent needs, such as for taxes or loan payments. Details on when additional capital contributions can or must be made, limits on the amounts and consequences if a member cannot pay should be included in the operating agreement.
- Departure of members. It is important for the operating agreement to address how to handle members that leave the LLC either voluntarily or involuntarily. Where it is involuntary, the agreement can state when and how expulsion of a member is allowed. Typically, it requires a vote by the other members and a buyout of the departing member’s shares. If the operating agreement does not address this, state law applies. A member also may be removed by a judge under applicable state law or a member can seek dissolution of the LLC from the court. Buyout provisions are also used for voluntary departures or when a member dies, goes bankrupt, or gets divorced. Such agreements allow members to buy out the interests of the departing member. Typically, there are guidelines in the agreement for determining the valuation of the departing member’s shares.
- Can a member sell their membership interest? – Right of first refusal, drag-along, and tag-along rights. Many companies generally do not allow the transfer of shares by default. However, an operating agreement may include exceptions for how a member can sell their shares. For instance, a “right of first refusal” gives the company or other members the first opportunity to buy a member’s equity before it’s sold to a third party. This provision helps business owners protect their ownership interests from outside parties. A “drag-along” provision allows a majority shareholder to force a minority shareholder to participate in the sale of the company. Minority shareholders must sell their interests to a third-party buyer under the same terms and conditions as the majority shareholders. In contrast, “tag-along” rights give minority shareholders the option, but not the obligation, to “tag” along with the majority to sell their shares when the majority shareholder receives a sale offer.
- Management structure. The LLC operating agreement should further specify whether the LLC is member-managed (the members are responsible for day-to-day operations) or manager-managed (certain designated members or outside appointees manage operations). In many cases, operating agreements will designate a lead member or a lead manager (or board of managers) to have authority to run the day-to-day business with certain “major decisions” requiring approval from the members.
- Dissolution and winding up. The agreement should specify when and how the business should be dissolved. Absent this, state law will apply. For example, New York and Florida laws have varying requirements regarding what must be done to wind up a business.
Conclusion
An LLC operating agreement is essential to avoid disputes that may damage your business. The best time to agree on how to resolve a dispute is before a dispute arises. Disputes between LLC members are costly, time-consuming, and often distract from the core purpose of the business. Contact us to discuss how we can help.
