Congratulations! You have formed a limited liability company (LLC) through the Secretary of State.
“That seemed so easy! My business partner(s) and I have got this – we don’t need to hire that exceptionally sassy attorney who told us that we HAD to hire her to get our LLC formed, AND there was nothing on the State’s website about that operating agreement thing she kept going on about.”
Above is a good example of some new business owners’ thoughts when they feel they can skip steps to save money. I can guarantee their thought process is MUCH different when they end up having conflicts with their business partners because they failed to put an operating agreement in place for their LLC.
So, what is an operating agreement? An operating agreement is a document between the people or other businesses that own an interest in an LLC. It outlines the businesses’ financial and functional decisions including rules, regulations and provisions. The purpose of the document is to govern the internal operations of the business in a way that suits the specific needs of the business owners.
What happens if you do not have one? It is true that in most states this document is not filed with any government agency. It is a private contract between the people who own the business. If you decide to skip this part of the business formation process, most likely you will then have to look to the statute (i.e. law) in your particular state to determine what your rights and remedies are in the event an issue arises between the business owners. So, if you don’t like what the law has to say about a particular issue, that is too bad! Most entrepreneurs don’t like the idea of someone or something controlling their destiny. Therefore, it is important that you take the time to get this document in place before you start operating your business.
Below are the 10 most important elements of any operating agreement. Some agreements are going to be lengthier and more complicated than others, but it will depend on the type of business and its owners.
- Equity Structure
Your interest in the LLC (called your membership interest) is most commonly referred to as a percentage. The membership interest is comprised of two components: 1) an economic interest and 2) a management interest. Due to the flexible nature of an LLC, the Membership Interest can also differ in various ways including voting and non-voting, common and preferred, etc.
- Capital Contribution
Its take two things to make a business run: 1) money and 2) sweat. Members of an LLC typically contribute one or both. If money or other assets of value are contributed, then capital accounts should be set up through the LLC’s accountant to keep track of what each Member has contributed financially to the LLC. If the Member is only contributing their knowledge and skills (i.e. “sweat”), that is not necessarily monetarily quantifiable.
- Allocation of Profits, Losses and Distributions
The operating agreement may alter the default rule of allocation of profits and losses whereby a Member’s equity share is also their share of the profits and losses. For example, a Member may own a 50% equity interest in an LLC but be allocated 100% of the profits and losses.
Most small business LLCs are considered Member-managed; meaning the equity owners of the business also run the day-to-day operations of the business. An LLC can also be Manager-managed whereby the Members of the LLC appoint a manager or managers to oversee the day-to-day business operations while the Members oversee larger more infrequent decisions.
Depending on the type of decision needed to be made, most small business operating agreements for LLCs require a simple majority of Members to carry a decision. However, many LLCs are two-member 50/50 members. In this case, I advise my clients to require unanimous consent for a list of specific decisions, including taking on new Members, purchasing property, taking on debt, selling the business, etc. For multiple-member LLCs, a supermajority may be required rather than unanimity.
Should the LLC ever need to take on new Members, those new Members would get their interest in one of two ways. The first would be from a percentage set aside by the LLC as “outstanding” to draw from in the event new Members are added to the business. The second would be to dilute the interests of current Members if 100% of the LLC interests have been distributed amongst the founding Members. Knowing how much your interest will dilute in this scenario is important to understand.
What happens if one Member wants out of the business? Most operating agreements require the transferring Member offer their interest to the other Members first before they can try to transfer it to a third party. This is called Right of First Refusal.
If a Member dies or the other Members agree to purchase a transferring Member’s interest, a process would need to be in place to determine how much the other Members buy out the transferring or deceased Member’s interest and when it would need to happen. Many operating agreements require the business to be valued in order to determine the fair market value of the departing Member’s interest.
If the Members decide to close the business, a very specific process needs to be followed in order to dissolve and terminate the business properly. First, the Members need to wind-up the affairs of the business. This usually means selling all the assets of the business. Once this is complete, the money generated from the assets would typically pay out as follows: first to outside creditors; second to any internal creditors; and finally, the remaining funds would be split between the Members depending on their equity share.
- Owner’s Manual
Finally, there are MANY things an LLC operating agreement does not include. I counsel my clients to take their ownership hats off and consider themselves employees of their business. What types of things are included in a handbook or benefit package that you would present to your employees? Things like vacation and sick policies, health insurance and retirement benefits to name a few. I recommend my clients create an internal document that all Members agree to abide by that includes many of these “soft” items. I also recommend the Members include their job titles, descriptions and duties in this document as well. This document will grow and change over time.
Keep in mind that an operating agreement for your LLC may require more elements than what we’ve listed above. To check that your operating agreement is as comprehensive as possible, you should work with an attorney who knows everything that needs to be included. At Schaffer Law Firm, we’ll work towards creating an operating agreement that can help prevent possible business disputes or civil litigation in the future.