A well-crafted LLC operating agreement is critical for the business and its owners. Ultimately, the operating agreement is the blueprint for how the company will be managed and addresses how payments will be made to the members, how transfers of ownership will be handled, what happens if a member dies or becomes permanently disabled, procedures for tax matters, and the requirements for meetings and voting of the members. The operating agreement is a contract between the members (owners) of the LLC outlining specific rights, obligations and terms on how the company will operate.
The best time to put an operating agreement in place is when the company is formed. This is when the members should set protocol down on paper and build a lasting structure that they can look to as the company grows, disputes flare up, confusion arises, and eventually, when the company sells or winds down. An operating agreement will aid in navigating future disputes or disagreements between the members.
Here are some basic questions and topics to consider and discuss with your business partners prior to engaging a lawyer to draft your operating agreement. These will help your attorney put together a robust, cohesive operating agreement.
- Management of the LLC. What specific roles will each of the members play in the LLC? For example, who will be the manager? You can have multiple managers, but you should consider spelling out the specific roles, responsibilities, and limitations on what each manager can do. You can be as broad or as specific as you want, but it is important to outline those roles and duties specifically. Setting limitations on the managers is just as important as setting forth their responsibilities. For example, there may be specific actions that require the vote of the other member prior to granting a manager the authority to act for the company. Some of these include items like spending over a certain dollar amount on company expenses, entering certain contracts, entering into loans, selling company assets, and the like. This is a section where checks and balances should be considered so that a manager is able to operate efficiently and handle day-to-day operations for the company without putting the company or the other members at unacceptable financial or contractual risk.
- Ownership Percentages. What ownership percentage will each of the members have? Is someone earning additional ownership through “sweat equity”? If so, how that ownership is determined should be spelled out in detail in the operating agreement so that expectations and metrics are clear from the outset.
- Goals and Purpose of the LLC. What are the overall goals and business purpose of the LLC? Do you want to put limitations on the types of business that the LLC can engage in?
- Capital Accounts & Working Capital. How much money will each of the members put into the company? How will the company handle capital calls or the need for more money from the members? Can the members be diluted if they don’t participate in the capital call? Can a member take any money out of the LLC? Bring in your company’s accountant to these discussions to offer her/his thoughts. Capital accounts should be set up at the outset of a company’s operations and should be tracked annually by your accountant/bookkeeper.
- Meetings and Voting Rights. How often should company member meetings be held? The default is annually, but most companies want to meet more frequently. Where will those meetings take place? What topics will require majority or unanimous voting by the members? Some things to consider are voting related to the sale of the company and its assets, admission of new members, electing managers, determining manager salaries, determining and making distributions to the members, entering into big contracts, buying real estate, taking out loans, and the like.
- Distributions. How are the owners going to get paid? There are generally two options, distributions and salary. Both have different tax repercussions. Will the company make mandatory tax distributions to the members? Remember, LLCs don’t get taxed directly; they are taxed as pass-through entities. This means that the members generally get taxed based on their ownership percentage in the company. Will distributions be based on the amount of work done by the members for the company or tied directly to the percentages of ownership? These are all important decisions to discuss with both your accountant and attorney.
- Death/Disability. How will the unexpected death of a member be handled? Will the company wind down, pay off debts and then distribute the money to the members and their heirs? You may not want the deceased member’s kids or spouse in the company. Will the company continue and then allow the deceased member’s heirs to join the LLC? Or will the company/members buy out the deceased member’s interest? If so, decisions need to be made regarding the valuation of the deceased member’s ownership and how the buyout payments will be made.
- Transfers of Ownership. Members may not want to bring on new partners without a majority or unanimous votes. Members may not want to bring on a member’s ex-spouse in a divorce. Consider what restrictions on transfer should be included in the operating agreement. Similar to dealing with death and permanent disability, the members need to discuss how they want to handle selling their interests, bringing on new members, and planning for potential divorce and bankruptcy of the members.
- Tax matters. Bring in the company’s accountant to discuss tax matters related to the LLC. Such items as accrual or annual accounting, tax distributions, capital contributions, and valuation of ownership interests should all be reviewed with your accountant.
- Dispute resolution. How will the members handle disputes between them? Can a member be removed for cause? What constitutes cause? Do members want to require mediation or arbitration for disputes? These should all be discussed and spelled out in the operating agreement.
- Miscellaneous. What other unique items are important to the members and should be included in the operating agreement? Discuss those items now and speak with your attorney about whether or not they should be included in the operating agreement or another LLC contract.
An operating agreement is a living document, and it may need to be updated from time to time. However, early dedication to crafting the operating agreement is time and money well spent for the members. A well-drafted operating agreement helps the company run more smoothly, clearly defines the rights and responsibilities of the members, and protects everyone’s investment.
(The opinions provided are for general informational and educational purposes only. No attorney-client relationship has been formed, nor does the content of these materials constitute legal advice. Craig T. Watrous is a Colorado business attorney with Mallon Lonnquist Morris & Watrous, PLLC, based in Denver, Colorado. Craig regularly represents limited liability companies. Craig can be reached at cwatrous@mlmw-law.com.)