When dealing with small businesses, one of the first things I ask is if it has an operating agreement. Unfortunately, the answer is a coin flip. If there is an operating agreement, my follow-up question is whether the members are aware of what is contained in the operating agreement and does it reflect the current nature of the company. Inevitably, I am met by blank stares. On the other hand, when entrepreneurs come to me to form their LLC, the operating agreement is where they try to “cut corners.” This post is an effort to end these risky behaviors.
WHAT IS AN OPERATING AGREEMENT?
Operating Agreements consume all of the negotiating and drafting time in organizing a limited liability company. What is an operating agreement? An operating agreement details the relationship of members as members of the LLC and between the members and the LLC, the rights and duties of any manager of the LLC, the activities of the LLC, and the conduct of those activities. However, the operating agreement also can serve as:
The bylaws and code of regulations;
Partnership agreement;
Buy-sell agreement;
Financial distribution contract;
Employment agreement;
Spendthrift protection document;
Intended statement of tax treatment;
Succession planning document;
Rules for executing respective tasks and obligations.
The operating agreement is the single most important document for your LLC. Thus, it vexes me when I meet business owners who (a) do not have an operating agreement and/or (b) do not know what their operating agreement says. The operating agreement is a living document and should be referred to regularly.
WHAT SHOULD AN OPERATING AGREEMENT ADDRESS?
Given the vast number of topics an operating agreement can address, it should answer the following questions at a minimum:
How are credits allocated for tax purposes?
How is cash distributed?
Who has management authority?
How are profits allocated?
How are losses allocated?
How are votes to be counted?
When is a vote needed?
What transfer restrictions apply to members?
Can a member withdraw?
What causes dissolution?
What standard of conduct and decision making is required?
What indemnification is available?
What vote is required for amendment?
What exceptions, if any, are there to members’ fiduciary duty to other members?
These questions can normally be grouped into three broad categories: Member Duties; Contingencies and Dissolution and Termination. In this post, we will discuss Member Duties. In the next post, we will take up Contingencies and Dissolution/Termination.
MEMBER DUTIES AND OBLIGATIONS
This section of the operating agreement addresses member liability, fiduciary duty, capital contributions, and allocations and distributions. Below is a brief discussion of these categories and how they may be addressed by an operating agreement.
Member Liability: Members have limited liability for the debts and obligations of the LLC. However, the operating agreement may explicitly state that the members will not be personally liable for the debts of the LLC.
Fiduciary Duties: LLC managers and managing members owe a duty of care and loyalty to the LLC. Members typically owe a fiduciary duty to each other. A fiduciary duty means that there is a relationship that requires undivided loyalty, trust, and confidence. There can be no conflict of interest between the principal and the fiduciary. Most states allow the operating agreement to limit this duty, but doing so will require very careful drafting. At the bare minimum, most statutes require a duty of good faith and fair dealing among members.
Capital Contributions: Capital contributions are the payments a member makes to the LLC in exchange for its LLC interests. The form and amount of the contribution are generally negotiated between the parties. The operating agreement also determines the circumstances when additional contributions (“capital call”) may be made.
Membership Interests: The operating agreement will also address how additional membership interests may be issued to new or existing members, as well as the effect such an issuance will have on existing membership interests. These provisions are closely negotiated, as they have broad implications for control of the LLC, as well as how allocations and distributions will be determined.
Allocations and Distributions: The members will need to negotiate how profits and losses are allocated, as well as when and how the company will distribute company funds. This is dependent on a number of factors, such as business considerations, percentage interests, capital contributions, tax status, and discretion of managers (if any). Ordinarily, the operating agreement describes how taxes are handled and then the priority of payments to the members and the circumstances such payments may be made. In a new business venture, I have seen provisions where distributions are postponed for the first year of operation and then quarterly if the company is profitable.
CONCLUSION
Hopefully, we have impressed upon you the importance of the operating agreement for the LLC. It is a multipurpose document that commemorates the relationship of the members with each other and with the company. As such, it is critical to (1) have an operating agreement; (2) know what is in the operating agreement and (3) make sure that it accurately reflects the intentions of the members.
Are you thinking of forming a new business? Or do you have an LLC and would like to make sure it is in good standing? Contact DeVougas Law Group for a free 15-minute consultation.
[Disclaimer: Nothing in this article constitutes legal advice. Please contact us in order to determine the appropriate course of action for your particular situation.]