Choosing to do business as a limited liability company, or LLC, may be the right move for many small businesses. An operating agreement is essentially a contract among the members that sets out the purpose and guidelines for the enterprise. Some states require a formal operating agreement; others do not, but it would be foolhardy to go forward in business without a clear understanding of the rules, particularly when money is on the line.
Downloading and filling out an online form may be tempting, but it confuses paperwork with a thoughtful plan. Here is a simple checklist of the things you should discuss with other members of the LLC and then with your business attorney to make sure that you have a strong foundation to grow your business in the future.
1. Do members want to limit the kinds of business the LLC may conduct?
LLCs are very flexible and may be set up to conduct any or all legal businesses. However, a member with great talent, interest and financial ability to contribute to a real estate venture may want out if the project turns into a restaurant chain.
2. What about capital contributions, for both the long and short term?
The agreement should specify how much each member is expected to contribute, and whether the contribution is in cash or in-kind, and in the latter case, what assets are contributed as in-kind contributions. An operating agreement may also provide for additional capital contributions and assess interest and penalties on unpaid contributions.
3. How should capital distributions be decided upon?
The agreement should also describe how distributions and dividends will be paid. These need not be paid in proportion to capital contribution if the members play different management roles.
4. What about meetings?
Most state laws require at least annual meetings, but these generally need not be in person. An LLC may choose to hold the minimum number of meetings, meet additional times on an as-needed basis or meet regularly on a more frequent basis. More frequent regular meetings may be an opportunity to force a decision making on underlying or dormant issues.
5. How will decisions be made?
Members may want to go with a simple majority or require a super-majority for some kinds of decisions. The voting rights of each member need not be the same. Voting may be based upon capital contribution or some other method.
6. How will the LLC be managed for day-to-day operations, and who will do it?
Some LLCs choose to be managed equally by all members, much like a traditional partnership. Others hire an outside manager, with the members retaining ultimate control and authority, more like the directors of a corporation. With the latter model, the operating agreement should set out hiring and firing authority. With a growing enterprise, the operating agreement may provide a specific trigger for reviewing the management structure on a periodic basis.
7. How will disputes be handled within the membership?
This, of course, will relate to other decisions about decision making power and possible exit strategies.
Governance and Growth
8. Will members be allowed to compete with the LLC?
It is probably safe to assume that your fellow members may be serial entrepreneurs and have multiple business interests. Those interests may take them elsewhere. It may not be disloyalty, but a byproduct of good connections. Decide in advance how you want to handle this nearly inevitable challenge. It may be wise to agree on the terms of a non-compete agreement in advance.
9. How might transactions between a member and the LLC be dealt with?
This is closely related to the previous question, and will require a careful conversation about the potential for conflicts of interest.
10. How are member wages, if applicable, to be calculated?
The agreement should cover how a managing member, if that is your business model, might be compensated.
11. Who will the LLC designate to deal with tax matters?
LLCs are an attractive form in which to do business because, although they offer members limited liability, like a corporation, members may be taxed on a pass-through basis, like partners. The operating agreement should also make clear how profits and losses are to be shared. These issues are going to be important, so it is best to have a member specifically designated to deal with them.
12. How should members be added or removed from the LLC?
Decisions about adding new members may be nearly as difficult as decisions about removing members and will require a fresh evaluation of decision making power, voting rights and capital contribution requirements.
Sometimes the hallmark of a star performance is knowing when to quit. Members may die, retire or decide to move on to something new. It is a good move to deal with these possibilities in the operating agreement.
13. Should members restrict the transferability of a member’s interest in the LLC?
The transfer of a member's interest to an outside third party without the consent of the remaining members could clearly be problematic. An operating agreement may also permit members to buy in another member’s interest in the event of retirement or or death or to compel the sale of a member’s interest in the event of an intractable dispute. The formula for valuing the interest in either event should be worked out in advance.
14. In the event a member exits, how should the interest be valued?
There are a number of options, sometimes based on mathematical extrapolation from capital contribution, sometimes factoring in other variables, including management role.
15. How will the LLC dissolve, and what are the procedures for winding up the LLC?
It may be a difficult decision, and it may be better to spell out the criteria in the agreement, rather than dealing with the issue on an ad hoc basis.
A well-crafted operating agreement is an important tool for building and managing your business. Some thoughtful conversations with other members at the outset and the assistance of a business attorney in drafting your agreement may avoid expense and legal complications at a later date.