Running a business is not easy. If you have your own LLC, then you must have an operating agreement for your protection.
Define: Operating Agreement
An operating agreement is a key document used by limited liability companies to outline the business’ financial and functional decisions including rules, regulations and provisions.
LLC stands for Limited Liability Company. The main reason you have an LLC is to limit your liability. The lack of an operating agreement can null and void the limited liability as courts can deem your LLC as a sole proprietorship. Also if you do not have an operating agreement, then all default State rules can apply to your LLC.
WARNING: Do not use a cookie cutter template. Investing the time and effort into a customized one will protect you in the future.
Here’s a list of items you should consider and put into your agreement.
- What is each members financial interest?
What percentage ownership does each member have? How will members be paid? When will they be paid? What rights do members have based on their respective membership interest? Right as in voting etc. The Operating Agreement must make provision for how expenses and revenues will be shared. These splits do not have to be in the same proportion as ownership interests. You can create any formula to be written into the operating agreement. When will distributions be made? The amount and timing of distributions can be set at management’s discretion, required at established times or triggered by certain events. LLC Operating Agreements sometimes include both required and discretionary distributions.
2. How do you define your Corporate Governance?
Who makes up the board or board of managers? How are they selected? Who can add more? Who can appoint them? What are the powers of members or managers? If the LLC is to be governed by majority rule, are there limits to what the majority can decide? If there are two equal members, how will they resolve disagreements? Try to keep no one person to have a majority, unless of course it’s for you.
Management-related provisions commonly found in an LLC Operating Agreement include:
- Appointment of the initial members of management.
- Procedures or triggers for removing or replacing management.
- The powers of management (frequently a broad list of permitted actions)
- Limitations on management’s authority, such as a requirement that members representing a certain percentage of interests (individually or in the aggregate) pre-approve certain actions.
Voting: There are two ways to split voting power among LLC members:
- each member’s voting power corresponds to his or her percentage interest in the business, or
- each member gets one vote — called “per capita” voting.
3. Corporate Officer’s Power and Compensation
What are the officers authorized to decide, and how are they appointed? What is corporate officers compensation?
4. Include a Non-Compete Clause
Recent court verdicts suggest that without a non-compete clause in the LLC operating agreement, a member may be allowed to compete with the business of the LLC. What is defined as competing?
5. Banking, Finance, Books and Records Audit
Who can see the books, board meeting notes, and financial documents? What is the procedure to get access and how quickly does it have to be given. If possible include a provision for all members to sign off on all payments made prior to money moving. A simple memo signed off on all transactions can be used. You can also use E-sign to simplify this. Also creation and use of bank accounts should be limited and all parties involved should have access.
6. What are the procedures for Arbitration/Forum Selection?
Which laws direct disagreements between members? Meaning which states laws are the contracts under? Where should a lawsuit be started? Or Can /Must disputes be settled through arbitration?
7. Departing of a Member
If a member wants to disassociate with the LLC or if you want that member removed, how does this get resolved? The operating should be clear on this issue as it comes up in all companies at one point or another and how will it be resolved. If the member is leaving how will their interest in the company be compensated. What the rules to remove a member?
8. Fiduciary duties.
Managers or managing members have a fiduciary duty to the company and other members that are part of the company. List out those duties. But the LLC operating agreement cannot “eliminate the implied contractual covenant of good faith and fair dealing.”
Will contributing to the LLC trigger income or estate taxes for the contributing member in the state where the LLC does business? Will the passive loss apply to an investment in the LLC? Who will file taxes and when? All issues that should be addressed in the operating agreement. Who will be able to take the loss and how much of it. As LLC can change who takes how much loss.
10. Exit Strategy
Someday you may want to transfer your business or will depart this world (if you die) and you will need to capture the value of your business. If the business you build has lasting value, a well-written operating agreement can help you reap that value for yourself. If you die, can your next of kin get ownership or how will they be compensated. If you want to decide at what point can you sell your ownership to other members and at what price? The valuation of shares section of the Operating Agreement will provide for a procedure on how to determine the Fair Market Value of shares. This value is often a very contended subject and, having a procedure that is determined beforehand helps navigate through this contention. Whether it is done through looking at the books or by an appraiser, valuation of the shares is important to determine beforehand.
11. Raising Capital & Admitting Additional Members
An LLC may require additional working capital in the future. The procedures for raising supplemental funds (either from existing members or by accepting new investors) are generally spelled out in the Operating Agreement. Will a dilution occur? Can someone veto a new member from joining?
Every LLC operating agreement should indicate in which situations the company could dissolve and be closed. The operating agreement can go an extra step to state whether members can request an involuntary dissolution from the Court. If it is dissolved who gets what assets?
13. Right of first refusal.
This section of the Operating Agreement concerns itself with the sale of the company and whether or not the company or the members have the right to purchase the shares before a third party does so. When you start a company, you are placing a certain amount of trust in your partners and this trust stems from knowing them. When one of the partners wants to leave and sell his shares, he may be selling these shares to party who you do not know, nor trust.
14. Who can edit this Operating Agreement and what is the procedure?
Who owns the assets? The company should all own assets not individual members or managers. This should be written into the agreement. This includes trademarks, domain names, etc
Any vendors should be approved by all manager / members.
17. Insurance – All necessary must be purchased and maintained to limit liability
18. Additional Funding – Fiduciary obligation would cause for all parties to contribute, if contribution cannot be made there would be a dilution. All parties must sign before a dilution, and all parties must agree additional funding is needed.
19. Transacting Money – Any payments made to anyone or any company should require a sign off by all parties via use of a memo or some document. If many transactions are about to happen they can be summed up in one large document but a sign must occur before payment.
20. Bank Accounts – There should be a standard of using one main bank. Any bank accounts created should have all parties on it.
THE AUTHOR OF THIS BLOG ARTICLE IS NOT A LAWYER AND THAREJA, INC. IS NOT A LAW FIRM. THE ARTICLE ABOVE IS NOT INTENDED AS LEGAL ADVICE AND SHOULD NOT BE TAKEN AS LEGAL ADVICE. THIS SHORT ARTICLE IS STRICTLY TO MENTION SOME ASPECTS OF CORPORATION LAWS AND/OR LAWS RELATING TO OTHER FORMS OF ENTITIES WHICH YOU MAY NOT BE FAMILIAR WITH. WE RECOMMEND THAT YOU CONSULT WITH A LAWYER BEFORE FORMULATING A STRATEGY WHICH WILL BE SUITABLE FOR YOUR SPECIFIC CASE.