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Important Topics to Cover in an Operating Agreement

August 30, 2021.

Important Topics to Cover in an Operating Agreement

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. Most states assume that a majority vote is sufficient for ordinary course decisions. 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.

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?  Almost all states allow membership interests to be transferred.  But 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.

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

You should also consider whether to include a non-compete clause.  This will prevent disassociated members from directly competing with your LLC.  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.

A non-solicitation clause should also be considered.  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. 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 specify 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 (instead, the income passes through the entity to the members, who then pay taxes on those earnings according to their individual tax rates).  Conversely, the operating agreement can elect for the LLC to be taxed twice like corporations.  How you choose your entity to be taxed can have wide ranging and significant impacts so be sure to think it through before settling on a decision.

DISSOLUTION

Finally, your operating agreement has to address how it all ends: Dissolution. Your operating agreement should outline events that cause dissolution, for instance, whether the death of a particular member would cause the dissolution of the LLC or whether the LLC should instead dissolve on a particular date.  Also, the operating agreement could state that dissolution occurs on a unanimous vote of the members, as most states follow, or (if a lower hurdle is desired) only on a majority vote of the members.

IN SUMMARY

You have great flexibility when drafting an operating agreement, limited only by your imagination.  Still, there are certain elements that all operating agreements should contain, and making sure to include them is vital.  In the end, the operating agreement needs to accommodate the unique needs of the business (including where it stands today, and where it is anticipated to be in the future).

 

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References

Newburn, Ryan.  “Important Topics to Cover in an Operating Agreement.”  Important Topics to Cover in an Operating Agreement | Newburn Law, P.C..  April 30, 2021.

 

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