Anatomy of an LLC Operating Agreement
Limited liability companies allow great flexibility for their Member-owners in structuring both economic and management matters. Consequently, when an LLC has more than a single owner, it is important for the Members to adopt an Operating Agreement spelling out how these matters should be handled. An Operating Agreement is similar in many respects and serves many of the same purposes as a Close Corporation Agreement does for corporations with only a few shareholders. Click here to read my blog post on Close Corporation Agreements.
In Ohio, if a written Operating Agreement is not adopted, Ohio Rev. Code Chapter 1705 contains a number of "gap filler" provisions that will be applied to govern the business and legal affairs of the limited liability company. While some of these may be just fine, others are not appropriate in every case. Moreover, in many cases, the "gap filler" provisions are rather vague and likely to lead to expensive litigation when applied to particular situations involving disputes among owners. I use an LLC Formation Client Questionaire with new clients to help gather information useful for tailoring an appropriate Operating Agreement for their particular circumstances.
A typical Operating Agreement sets forth the ownership interest (known as a Membership Interest) held -- and initial capital contribution made -- by each Member and also contains provisions regarding the following:
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purpose for the LLC
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allocation and distribution of profits and losses
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voting rights and procedures
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protocol for member (and manager) meetings
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admission of new members/restrictions and procedures for transferring ownership
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dissolution and winding up of the company
Sometimes an Operating Agreement will also include special provisions regarding the duties of Members and/or Managers. For example, Members or Managers may be required to devote their full attention to the business affairs of the LLC; alternatively, the Operating Agreement may specifically provide that they are free to engage simultaneously in other business ventures. Noncompete or confidentiality provisions similar to those often found in employment agreements may also be included in the Operating Agreement. Members or Managers who fail to comply with these restrictions may be subject to expulsion and forced to sell their Membership Interests if the Operating Agreement so provides.
Purpose for the LLC. Generally the Operating Agreement will provide for very broad purposes for the LLC. However, in particular cases, it may make sense to limit the particular activities in which the LLC is permitted to engage.
Allocation and Distributions of Profits and Losses. Unlike a corporation, the economic rights attached to equity ownership in an LLC do not automatically track the relative ownership interest held by the Member. Thus while a shareholder with 25% of the shares of stock in a corporation (regardless whether an S or C corp) must receive 25% of the corporation's profits and losses. By contrast, an LLC Member with a 25% Membership Interest might receive only 10% of the Company's profits and losses, or 50%, or any other amount the Members have determined to be appropriate. An Operating Agreement can also accomodate various creative arrangements such as ones in which particular Member(s) get a certain percentage of profits and losses up to an aggregate amount at which point a different formula becomes applicable. The possibilities are limited only by the imagination and desires of the Members.
In addition, the timing and rights, if any, for Members to insist on any minimum distributions is often included in the Operating Agreement; whether it should be delineated sometimes depends upon whether one is cosdidering it from the standpoint of the majority or minority owner. In the absence of any specific provision requiring distributions periodically or in any set amount, Members have no right to insist on distributions.
Voting Rights and Procedures. In a corporation, voting rights follow the number of shares held. In C-corporations, voting rights can be restricted by giving different classes of stock different rights, but in S-corporations, that is simply not an option. In an LLC, just as with allocations of profits and losses, the nature and procedure surrounding voitng rights is essentially completely up to the Members to determine. If the Operating Agreement does not otherwise provide, Ohio Rev. Code 1705.24 allows Members to vote in proportion to their contributed capital just as they would in a corporation.
An LLC can be governed in much the same way as a corporation with Members holding "Units" or it can more closely resemble the ways of a partnership. Members in an LLC can decide to vote by their "Uits" or Membership Interest percentage in a fashion similar to that of shareholders in a corporation. They can also decide to vote by "headcount" with each Member being entitled to one vote. It is also possible to have some issues determined by headcount and others by Membership Interest percentage. The Operating Agreement can also designate certain matters as requiring a unanimous vote or a specified supermajority to be properly authorized.
In addition, Members can choose to have the LLC's business and financial affairs handled solely by Managers (who function somewhat analogously to Directors or Officers in a corporation) rather than by the Members. Here the Operating Agreement spells out the procedure for selecting Managers and voting procedures governing their deliberations.
Protocol for Member (and Manager) Meetings. The Operating Agreement will typically set forth how often meetings will occur and explain how Members (and Managers, if applicable) can call a meeting. Members can also decide whether participation by telephone or other electronic means should be permitted
Admission of New Members; Transfer of Membership Interests. Generally, the Operating Agreement will contain some sort of restrictions on the transfer of the respective equity ownership interests held by individual Members. Often there will be a right of refusal granted the LLC and other Members which requires a Member wishing to sell his Membership Interest to allow the company and/or his remaining fellow Members to match any offer obtained from any third party. In addition, the Operating Agreement can require a Member to sell, or the LLC to buy, a Membership Interest under certain circumstances such as in the death, disability or termination of employment by the company; in these cases, the Operating Agreement should also specify a procedure or formula for determining the appropriate purchase price.
Dissolution of Company. The Operating Agreement should also provide for the circumstances under which the LLC can or should be dissolved. Generally this includes by uanimous consent of the Members or by judicial decree, but depending upon the nature of the LLC's business, other triggers may also be appropriate.
Conclusion. The process of working through the Operating Agreement can be a useful one for Members of the new company as it provides a vehicle for discussing many important issues.
