This article has been written by Ayush Tiwari, a student at Symbiosis Law School, NOIDA. This article aims to discuss what an operating agreement is, what should be included in an operating agreement, its advantages and disadvantages, and when one is needed.
It has been published by Rachit Garg.
If you want greater personal protection but less formality in your business structure, forming an LLC, or limited liability company, is a good alternative. When you start a limited liability company, you create your company’s operating level agreement. Regardless of your company’s structure, certain paperwork, such as an operating agreement, is essential. LLC operating agreements are vital for establishing the core rules, regulations, and standards for the company. The intersecting realms of business and law may be the ideal method to establish an LLC firm. The agreement will assist the company in gaining trust. Read this article to learn about the many critical reasons to create an LLC operating agreement, as well as examples and procedures. Hence, if you wish to incorporate your business as a limited liability company (LLC), you must first learn how to prepare an LLC operating agreement, and before that, you should know what an LLC is.
Does every business need an operating agreement
If you form an LLC in Delaware, Maine, Missouri, or New York, state law requires one to draft an operating agreement (but not required to file it with the government). Even though one’s state does not need a formal company agreement, one should bear in mind that this document is critical to the internal operations of the firm. Although an operating agreement is not legally needed for LLCs in the remaining 45 states, it is strongly recommended.
An operating agreement clarifies crucial corporate operations, such as how revenues and losses are distributed and which members have the right to commit the firm to legal contracts.
As a result, multi-member LLCs can adopt this agreement to limit the likelihood of member conflicts. An operating agreement may also assist single-member LLCs, especially if the sole member depends on management to execute company activities. Without an LLC Operating Agreement, all legal proceedings taken against your firm will be governed by the requirements of your state’s LLC legislation. Making an operating agreement gives you more say over the regulations that govern your firm’s management.
Similarly, no state requires corporations (S corporations and C corporations) to have an operating agreement. Nonetheless, experts urge the owners of these firms to prepare and implement their own form of operating agreement, known as bylaws.
So, as we now know, operating agreements are generally for limited liability companies, so we should first understand what a limited liability company is.
Limited Liability Company
What is a Limited Liability Company
LLC is an abbreviation for Limited Liability Company. A Limited Liability Company (LLC) is a unique sort of private limited company in the United States. It is a business form that combines the pass-through taxes of a partnership or sole proprietorship with the limited liability of a corporation. The term “limited liability” refers to the fact that all LLC owners are protected from personal liability for corporate debts and claims. This implies that if the company cannot pay a creditor, such as a supplier, lender, or landlord, the creditor cannot lawfully confiscate an LLC member’s home, car, or other personal belongings. As only LLC assets are used to pay off corporate obligations, LLC owners are only at risk of losing the money they invested in the LLC.
In a nutshell, an LLC is a company structure that combines the personal liability protection of a corporation with the organizational and tax flexibility of a partnership. It is known as a “hybrid” entity because it possesses characteristics of both a corporation and a partnership.
How is a limited liability company formed
A limited liability company must be established in accordance with state law. People form an LLC by submitting the proper papers to the appropriate state agency, which is usually the secretary of state. The majority of governments require the submission of articles of organization.
These are public papers, similar to articles of incorporation, which establish a corporation as a legal entity. The LLC is formed on the same day that the articles of incorporation are filed and the fee is paid to the secretary of state. The basic criteria for the articles of incorporation vary from state to state. It usually includes the name of the LLC, the name of the individual who formed the LLC, the term of the LLC, and the name of the registered agent for the LLC. Some states additionally need information about the LLC’s membership and management structure, as well as its intended purpose as a business. In all states, the name of an LLC must include words or terms distinguishing it as a limited liability company. Its title should contain the precise term “Limited Liability Company” or one of its various abbreviations, such as “LLC” or “Limited Liability Co.”
Structure of a limited liability company
Members of an LLC are its owners, and they are similar to traditional shareholders in numerous aspects. According to the law, a member might be an individual, a business, a partnership, or any other sort of organization or entity, in contrast to companies, which may be formed by a single shareholder. But most states require at least two members to form and run an LLC.
As a result, sole proprietors are not able to establish LLCs. Furthermore, unlike certain closely held firms or S corporations, which are limited to a particular number of stockholders, LLCs may have any number of members above one. State regulations generally mandate the organizational structure of an LLC. Most states let members administer an LLC independently or delegate administration to one or more managers. The management of an LLC is often elected or selected by the members.
In certain LLCs, more than one manager may be present. The manager of an LLC, like a managing partner in a limited partnership or an officer in a corporation, is in charge of monitoring the company’s day-to-day operations. A manager’s duty of care and commitment is to the LLC. Without the permission of the members, a manager may not work with the LLC’s rival company or use LLC property for personal advantage. Management is also forbidden from exploiting an LLC’s commercial opportunities or engaging in self-dealing unless the members agree to the activity after being fully informed of the manager’s intent.
What is an operating agreement
A limited liability company (LLC)’s Operating Agreement is a legal document that best suits its provisions to the needs of its members. It also logically organizes the financial and functional decision-making processes. It’s analogous to the articles of incorporation of a corporation, which regulate how it functions. The operating agreement can establish ownership and structure, as well as designate the registered agent, offer specifics such as when meetings are conducted, appoint management and describe how the firm can add or dismiss members.
Although the development of an operating agreement is not required in most states, it is recognized as a vital document that should be included when incorporating a limited liability company. When each member (owner) signs the agreement, it becomes a legally enforceable set of rules that they must abide by.
The agreement is structured so that owners can operate their firms according to their own set of rules and regulations. Also, if you do not have an operating agreement, your business will run under the state’s default regulations.
The importance of an operating agreement
By using an operating agreement, you can secure your limited liability status, prevent financial and management difficulties, and guarantee that your company is conducted in accordance with your own regulations rather than those imposed by the state. Even if you are the sole proprietor of an LLC, it is advisable to operate it under an operating agreement, even though many states do not require them.
What is the purpose of an operating agreement
A business agreement’s goal is to formulate your personal set of rules for doing business. An operating agreement is a legal document that, when signed by LLC members, binds them to its terms and conditions while also removing any potential internal concerns that might jeopardize the LLC’s ability to function and prestige. The operating agreements are adapted to the needs of the firm and ensure that everything runs smoothly and without disagreement.
Legal requirements of an operating agreement
An LLC operating agreement is required in the majority of states. This has caused considerable confusion because the Delaware LLC Act, 2014 states that an operating agreement might be oral, written, or both. If no written or oral agreement exists, it is presumed that the participants desire to be governed by the default terms, which is what is meant by an implied agreement. Even if a state does not need one, having an operating agreement in writing is still a prudent business move. Too often, when forming an LLC, the members depend entirely on verbal agreements, which can lead to disagreements or misunderstandings later on. Members who have a documented operating agreement have set rules to which they may refer in the case of a disagreement. A lack of an operating agreement, whether written or verbal, might also expose LLC members to state legislation, which may not represent the members’ intentions and can be unclear, leading to ambiguity. When the legislation changes, the LLC may find itself operating under constraints that the members did not expect when the organization was founded. Every year, over a dozen states update their laws. Some of these amendments are minor, while others may have a significant impact on LLCs formed or operating in that state.
Need of an operating agreement for a single-member limited liability company and a multi-member limited liability company
Single-member limited liability company
Even if a single-member LLC cannot engage in an internal dispute, you should nevertheless prepare an operating agreement since single-member LLCs may be considered sole proprietorships in legal procedures. An operating agreement, on the other hand, serves as a legal declaration of your LLC’s organizational structure that may be used in court to show your separation from your LLC. An operating agreement may persuade the court to keep your limited liability protection in place. If you are the only owner of an LLC, providing it with an operating agreement gives it legitimacy. An operating agreement in place helps to ensure that your LLC’s limited liability status is upheld by the courts.
Multiple-member limited liability company
An operating agreement will help prevent misunderstandings if you are a Multi-Member LLC by explicitly identifying partner duties and obligations. An LLC operating agreement may serve to protect its members’ limited liability status, which may mean they are not liable for any debts or legal proceedings committed by the firm. If the terms and conditions of an LLC are not established in writing and agreed upon, the rules are useless in the event of disagreement among members. An operating agreement, which incorporates business and operating agreements, acts as a governance model in the case of a disagreement.
Why do you need an operating agreement
An LLC operating agreement is necessary for some states. This is sometimes only necessary if the LLC has more than one member. Even if it is not required by law, an operating agreement provides some key functions:
To safeguard the integrity of your agreement in front of your state
LLCs that do not have a written operating agreement are subject to state default rules. This means that each state has a set of standard regulations that apply to businesses that do not establish operating agreements. Since the state’s default laws are so wide, it is not suggested that you depend on a regulating body in the state to monitor your agreement.
Creating a financial and managerial framework
Co-owned LLCs must keep detailed records of their profit-sharing and decision-making procedures, as well as how they manage new and departing members. Without an operating agreement, you and your co-owners will be unable to address financial and managerial conflicts. Furthermore, your LLC will be subject to the default operating guidelines imposed by your state legislation.
Making certain that your limited liability status is safe
Making an operating agreement can help ensure that courts recognize your limited personal liability, which is the primary reason for doing so. This is critical because, in the absence of a legal agreement, a one-person LLC may resemble a sole proprietorship. A properly documented operating agreement will improve the credibility of your LLC’s independent existence.
To establish explicit verbal agreements
Even when members have formally agreed to certain terms, miscommunications might arise. Operating terms and other business agreements should always be handled in writing so that they may be referred to whenever a disagreement arises.
Override default rules of the state
Unless your operating agreement states otherwise, some of these restrictions will apply to your organization. Each state has rules outlining the basic operating processes for LLCs. They are known as ‘default rules.’ For example, the default rule in many states requires owners to divide LLC income and losses equally among all members, regardless of each member’s position in the firm, which appears to be unjust to the shareholders’ interests. To avoid this, your operating agreement must state how you and company co-owners will distribute earnings and obligations. Rather than being compelled to follow default rules that may or may not be appropriate for your LLC, writing an operating agreement allows you to select the rules that govern your LLC’s internal activities.
What should be included in an operating agreement
A variety of issues must be addressed in an LLC operating agreement, some of which will be dependent on your company’s unique requirements and circumstances. Even though they look simple, each requires you to make some critical decisions, which you should incorporate into your operating agreement. Most operating agreements include the following:
In exchange for their financial contributions, LLC owners get ‘distributive shares,’ which are shares of the LLC’s profits and losses, as well as ownership interests. Most operating agreements stipulate that each owner’s distributive share reflects their separate ownership interests in the LLC. If your LLC wants to allot distributive shares that aren’t proportional to the owners’ percentage ownership interests in the LLC, you must follow the ‘special allocations’ requirements.
The shareholders of an LLC frequently supply the company with startup capital in the form of money, assets, or services. In exchange, each LLC member receives a part of the LLC’s assets. Members of an LLC, on the other hand, are free to divide ownership in any way they see fit. Members frequently receive ownership percentages that are proportional to the amount of money they have paid. These donations and percentage interests are specified in the operating agreement.
In order to make a significant decision in an LLC, a formal vote is necessary. There are two methods for assigning voting rights among LLC members:
- The voting power of each member is determined by their percentage ownership stake in the firm, or
- Each member gets one vote in per capita voting.
The majority of LLCs distribute votes based on the members’ ownership interests. Whatever method you use, be certain that your operating agreement specifies each member’s voting ability and whether a majority vote or unanimous approval is required to make a decision.
Changes in ownership
Many new business owners do not consider what would happen if one of them retired, died, or wanted to sell their ownership stake in the company. The operating agreements should include a buyout plan or the steps that will be followed if a member leaves the LLC for whatever reason.
Include the name of the company, the industry in which it operates, a description of the services it provides, and the address of its headquarters under this heading. Consider providing a statement of your company’s mission that defines the goals you intend to achieve.
Profit and loss distributions
Your operating agreement must state the distributive share of each shareholder and answer the following questions:
- How much of the LLC’s revenues must be distributed to its shareholders each year?
- Can shareholders expect the LLC to pay them at least enough to cover the income taxes they will have to pay on the distribution of LLC revenues each year?
- Will the LLC make regular distributions of profits, or are the shareholders free to take whatever they decide to choose from the company’s earnings?
Since you and your co-shareholders may have different financial demands and marginal tax rates, also known as tax brackets, you should pay special attention to the distribution of profits and losses. You may want to have the allocation provision of the operating agreement reviewed by a tax specialist to check that it fulfills the general aims the shareholders have in mind.
People should know all the information regarding the management and how it functions, such as:
- Who is in charge of the company? (the members or designated managers)
- How frequently do members meet?
- The importance of each member’s vote, and
- Which decisions require unanimous approval.
Describing the operating and financial aspects of your LLC is very necessary as there should be no confusion on how the company works, including:
- The company’s tax classification, (whether it is a disregarded organization, a partnership, or a corporation)
- The end of your company’s fiscal year
- Whether you will opt to ignore the unified tax audit regulations (if they apply to your organization).
- How to distribute profits and losses among members (either in equal shares, a predetermined percentage, or proportionally to capital contributions).
- Which reports should be included in the yearly report of members? (For example, income and balance sheets)
Details of the members or shareholders
Describing the rules that your LLC’s members must follow is another essential component and can be as follows:
- How to share assets if a member resigns or the firm is dissolved.
- The likelihood of a member willingly quitting the LLC.
- When and if a member is permitted to compete with the business.
- How are new members admitted?
Each member’s tasks and roles must be defined:
- Full name and address,
- The value of their capital contributions (including cash, equipment, and sweat equity),
- Their membership level (for example, Class A members have full voting rights, and so on), and
- The percentage of ownership.
The operating agreement may also specify who is allowed to sign contracts on behalf of the firm and how disputes will be resolved.
Top clauses of an operating agreement
The following are the major provisions that must be included in every operating agreement:
The name of the LLC, as well as the first registered office and primary business office addresses, must be included.
Declaration of intent
This contains a confirmation that the agreement conforms to your state’s legal requirements. It must also say that the company will be active as soon as the official LLC paperwork is filed with the state.
Objectives for the company
This includes a statement of the LLC’s objectives, which must describe the type of business. It typically includes a second clause, such as “and for any other permitted business purpose,” to allow for any future changes you may decide to make.
Admission of new members
This section explains how to acquire an interest in the LLC. If there isn’t one and you later wish to add a partner, you may always start over with a new operating agreement.
Term of LLC
For the vast majority of LLCs, this will indicate that the LLC will continue to exist until it is dissolved pursuant to state law or terminated in accordance with the operating agreement. If an LLC was formed for a specific reason, such as to construct and sell a commercial building, it may only exist for a set period of time or until a specific event occurs. It is important to indicate whether the LLC wants to be taxed as a corporation, partnership, or sole proprietorship in the tax treatment section.
Information of managers and members
It lists the names, addresses, and titles of the founding members. It also offers information about managers.
It shows each member’s initial capital contribution (and its worth), which might be money, goods, or services.
Additional capital investments
There are times when a company needs to raise more capital. Some agreements declare it unlawful to require any member to make additional contributions, while others allow it. Separate arrangements may also be included to modify each member’s proportionate participation in the firm if further contributions are made.
It will include information on manager management, such as any salary to be paid, the method for selecting managers, authority restraints, the duration of managers’ terms, the constitution of a quorum, and so on.
Admission and exit of members
It is beneficial to include clauses that describe the procedure for admitting new members, what happens if a member wishes to leave, the reasons for a member’s expulsion, and the actions involved in expulsion.
It tries to explain how a member’s LLC interest is transferred. If a member wishes to sell, the other members have the option of acquiring the remaining member on the same terms as a possible third-party buyer, according to operating agreements.
Obligations and remuneration for members
You can indicate which services workers are accountable for supplying in order to manage the business and whether or not they will be compensated for those responsibilities.
Distribution of revenue
Each member frequently receives a percentage of the company’s revenues or losses based on his or her ownership interest. This section may also include information on the frequency with which profits are distributed. Since members of an LLC are taxed on the LLC’s revenue, it is critical to consider whether distributions will be sufficient to satisfy the unpaid taxes.
Death of a member
Its aim is to clarify what happens to a member’s interests after they die. Common provisions allow the remaining members to purchase the interest, specific parties (such as a spouse or child), or the interest to be passed to an heir with the option for the surviving members to purchase the interest first. Another approach is to include a clause that allows for transfer but limits the transferee’s profit rights and eliminates them from decision-making authority.
The terms and conditions for terminating the LLC must be stated. Although the essential provisions of LLC operating agreements have been discussed, this is not an exhaustive list of all potential clauses. There are various practical, legal and tax concerns to consider when writing an LLC operating agreement that matches your specific objectives.
Meetings and voting among members
This provision will define how, when, and where votes will be taken, how many members must be present for a quorum, how many votes are required to pass an action, and so on, as well as the days and times of member meetings. It must state whether each member has one vote or if they all have the same number of votes based on their percentage ownership of the LLC. Also, explain if a majority or unanimous decision is required. You don’t want a quorum to be too small, allowing only a few members to act, or too large, especially if the number of members is large enough that one or two individuals could prevent action.
Benefits of an operating agreement
Even if a company just has one owner/employee, it might be useful to formalize the connection with an LLC operating agreement. An operating agreement creates a legal barrier between the LLC and the owner, ensuring that the owner is not held liable for the LLC’s debts or obligations. Otherwise, the LLC’s creditors may seek the owner’s personal assets.
An operating agreement also allows the owner to formalize their company’s succession laws, as well as governance processes such as meetings and voting. Without an operating agreement, the business’s ownership is handled according to the state’s default LLC laws.
Common mistakes with an operating agreement
According to experts, company owners make the following mistakes when creating operating agreements:
Failure to include critical information
When trying to set up your company’s operating structure, it might be tempting to skimp and skip over portions of an ideal operating agreement’s foundation. But each component of that system has a purpose. Each outline component must be included.
Using general terminology
An operating agreement must be clear and straightforward. Working with an operating agreement expert can help you prevent misunderstandings or ambiguities in the agreement’s terminology.
Too much information was supplied
As we have seen, omitting crucial information is bad. The inverse is also true if your operating agreement is overly detailed; that’s bad too. A lawyer with knowledge of LLC matters can identify terms that may cause more problems than they solve.
Ineffective management provisions
The majority of state limited liability company legislation recognizes two types of LLCs:
- member-managed, in which each member has the opportunity to actively engage in business management; and
- manager-managed, in which one or more managers are granted the responsibility to oversee business management.
In both forms of LLCs, the operating agreement must specify who makes decisions and how they are made. However, operating agreements usually either fail to address these core notions or do so in an imprecise and difficult-to-implement manner. The most prevalent risks of a poorly designed operating agreement are failing to:
- Determine which managers or members have authority;
- Dissolution, the sale of all or almost all of the LLC’s assets, and other major decisions require further approval;
- Discuss how managerial decision-making deadlocks are resolved; and
- Determine how the decisions and authority of many managers should be managed.
An operating agreement should lay out just how much influence the management or members have over how the firm is managed. The operating agreement should provide clarity to ensure that everyone’s expectations are clear before embarking on a business endeavor and to reduce the chance of misunderstandings or future problems.
Unawareness of how allocation and distribution provisions work
There are two major approaches to profit and loss distributions in operating agreements:
1. A “targeted allocation,” in which liquidation is defined and losses and profits are allocated in accordance with a fictitious liquidation event.
2. A “layer cake” technique, in which losses and earnings are allocated in layers and allocations are formed in accordance with positive capital account balances.
It is critical to completely understand these diverse strategies when drafting allocation and distribution laws to guarantee that the intended outcomes are accomplished. If these concepts are misconstrued or muddled, the whole framework may be drastically affected.
Maintaining the status quo
A strong operating agreement is dependent on being reviewed on a regular basis to ensure that it is still applicable and legitimate. According to experts, your agreement should be reviewed by a lawyer once a year to search for potential areas for change.
Misconception about the difference between distributions and allocations
Understanding the difference between distributions and allocations is critical for understanding how an operating agreement should manage both. An allocation of profits and losses refers to the sharing of earnings and losses among members for accounting and tax purposes. Distribution, on the other hand, is when the LLC distributes money or property to its members. This crucial distinction is commonly misunderstood by both professionals and clients.
To address this, it may be prudent to establish minimum distribution requirements that satisfy the members’ tax obligations related to the allotted revenue. It is also critical to investigate how and when distributions will be made. The operating agreement frequently does not go into great depth regarding these options. Even if each business is unique in certain aspects, it is critical to explore these concepts to ensure that the parties’ financial expectations are met.
Can an operating agreement be changed afterward
In general, LLC operating agreements can be changed. The technique, however, will vary based on the layout. In most circumstances, the method for amending an operating agreement should be described in the agreement itself. Some LLCs, for example, may declare that amendments can only be made with a unanimous vote of the members or during the fourth quarter of the year. An LLC may even have a non-changeable operating agreement. If not clearly stated, the method for changing an operating agreement is governed by the default regulations for LLCs in that state. The operating agreement for your LLC must always be kept up to date. The operating agreement must be amended if something changes within your LLC. Members, management, the LLC’s name, address, and other physical features, as well as financial and operating aspects, may all change. Once your membership has accepted the changes, you may file the amended documentation with the secretary of state in the state where the LLC was formed, if required. They should also be included in the legal documents of the LLC.
What’s the difference between an operating agreement and an article of incorporation
An operating agreement is an internal document that governs how business owners connect to one another professionally. An article of incorporation (certificate of formation) is a public document that legally creates a business as a corporation; hence, these are different from each other. These documents work together to form your organization’s legal foundation. Some more of these differences include:
- Operating agreements and articles of incorporation differ in terms of legal form, duty, state requirements, tax implications, comprehensiveness, and rigidity. Operating agreements are frequently less formal and more easily amendable.
- Articles of incorporation are submitted on the day of formation and are frequently not updated to withhold shareholder information, profit distribution techniques, or other ongoing business relationships, whereas operating agreements may be quickly amended to reflect the current status of operations.
- It is also critical to recognize that while they serve the same purpose, operating agreements and articles of incorporation differ slightly. Operating agreements typically go into deeper detail than articles of incorporation.
- In the case of a company, it is fairly normal to develop additional agreements, sometimes referred to as shareholder’s agreements, that define in greater depth the information that would generally be covered inside an operating agreement.
Similarities between an operating agreement and articles of incorporation
Operating agreements and articles of incorporation work together to form your company’s legal framework and specify its business structure. They do, however, contain certain similarities and overlap. Some of these similarities are:
- Both documents, for example, include vital business information and have identical functionality and design.
- Both the operating agreement and the articles of incorporation offer information about the business, such as the business name, purpose and how the businesses operate. Furthermore, these agreements establish the ownership structure and are required for understanding the business’s function.
- Every LLC should have a documented operating agreement and certificate of formation, and every corporation should have bylaws and articles of incorporation. Remember that submitting these documents incorrectly might cause delays. It is suggested that you get legal advice for assistance in the correct drafting and filing of these governance documents.
The distinction between bylaws and operating agreements
Operating agreements and bylaws are both used to govern the internal operations of a registered corporate body, but they differ in several ways. Operating agreements are often more detailed than a corporation’s bylaws. An operating agreement is a record of an LLC’s internal policies, whereas bylaws are corporate internal governing papers. Both are legal agreements. The parties to each contract, however, differ:
- Everyone who signs an operating agreement agrees to be bound by it. A corporation’s board of directors, on the other hand, sets and executes bylaws but is not compelled to obey them.
- Only five states in the United States of America require an LLC operating agreement. In contrast, 36 states require companies to have bylaws.
- Operating agreements are usually more extensive than bylaws and contain matters such as the percentage capital contribution of members, how profits and losses are divided, and taxation.
How to negotiate an operating agreement
The operating agreement is the most important document that will govern your LLC during its existence. These criteria may be difficult to negotiate, but without the backing of your operating agreement, any issues will be far more difficult to resolve. Before beginning a partnership with partners and investors, go through the terms and conditions of the operating agreement with your attorney to ensure you understand and agree.
When negotiating on their behalf, minority members of an LLC must carefully evaluate their special circumstances. People in the minority may have restricted or no voting rights, a small number of votes, or enough votes but not enough control. Although the minority lacks voting power, it may nevertheless have bargaining leverage if it is significant management or a contributor, has access to the opportunity, controls the agreement, or owns the firm but sells the majority part. In every negotiation, knowing your leverage is critical. Counsel should emphasize minority access to information, minimize minority risks, and ensure there aren’t many possibilities for the majority to cause trouble.
The purpose clause
The purpose clause, a frequently overlooked clause, grants the LLC broad authority to engage in any legal activity permitted by law and limits the scope of that authority by referring to the project in general or even further restricts the purpose by only addressing the specific purposes of certain matters specified. The purpose should state clearly what the members want the LLC to achieve. By enabling a very broad purpose, the majority may be permitted to extend the firm or operations to ones that the minority never envisaged when the initial arrangement was formed. By restricting the purpose, the minority prevents an undesired expansion of the LLC’s operations.
Voting and Control
The minority should consider the LLC’s decision-makers and their processes. Counsel for minority members must, at the very least, ensure that they have a say in issues affecting their economic interests or fundamental rights. As a side note, attorneys should consider how to terminate management. A minority will find it difficult to dismiss the manager if they are also the majority in interest. Consider negotiating for the manager’s removal if particular conditions, such as severe negligence or dishonesty, qualify as “cause.” The components of “cause” must be defined, and the appropriate standard of proof must be established.
Additional funds are needed.
Counsel analyzing these sorts of agreements should be concerned with how fresh capital calls are made and the consequences of failure to contribute adequate capital. Typically, the manager or the majority would require additional funds, leaving the minority no choice but to agree. In some cases, legal counsel may be able to negotiate a quantum on needed capital contributions or insist that any additional capital satisfy a proven “need.” There will almost always be a penalty if any member fails to pay the appropriate capital contribution. Other members may be able to contribute the required capital, thereby reducing the penalty for the non-contributing member. The other members may make a contribution on behalf of the non-contributing member, treating the contribution as a loan with no voting rights or dividends for the non-contributing member until the loan is entirely recovered, or the dilution may be pro-rata or include an extra penalty. Non-contributing members may be pushed to sell under unfavorable circumstances, like price and terms. Counsel representing the minority must focus on these clauses since they are not intended to benefit non-contributing members.
Resolution of disputes
In most operating agreements, the manager is the only party with authority to make crucial decisions, which may be the only circumstance that leads to an impasse or the only method to start a conflict that has a possibility of being resolved. If no meaningful alternatives are presented, the current arrangement would continue. In the event of a disagreement for which approval cannot be obtained, the status quo would be maintained. Another option is to allow for a third-party resolution, supplied by a professional or other trusted parties, to break the deadlock. However, this is usually more useful for commercial decisions than judgments on the company’s disposition. The inclusion of mediation or arbitration, as well as the provision of a purchase option, is almost universal. If a key decision is postponed due to a decision-making process, consider the impact on the business and whether the opportunity to carry out the major decision will pass during the time it takes to resolve the issue while considering dispute resolution procedures. In most cases, filing a lawsuit is the default course of action for breaking a deadlock. It is necessary to pay special attention to these provisions because they might be complicated and have unanticipated consequences for your business and shareholders.
Obligations of control persons
The common law requirements of fair dealing and good faith provide little protection. So because LLC is a product of a contract, counsel may not want to rely on the Act for protection. The obligations or the prerequisites for the obligations should be included in the operating agreement. Counsel may wish to establish a case for management or majority constraints. Consider whether the minority is involved in competitive or similar activities (i.e., counsel should require or eliminate any duty to provide other business opportunities or investments to the LLC). Counsel should consider limitations on extracurricular activities depending on the “bargain.” Outside activities are generally not prohibited unless the management or member in question is employed full-time by the LLC. If the “deal” is intended to operate a specific company, counsel may wish to consider related party transactions, which frequently require consent from the minority, or the LLC establishing a new business. Any acts that may be in contradiction with or connected to the objectives of the LLC should be forbidden. Indemnification and promotion arrangements are made in advance to cover the cost of representing a ‘covered person’ in court. Typically, an advance must be specified in the LLC.
Since the majority of regulations contain conduct restrictions that void indemnification, it is critical to examine them properly.
Members’ statutory inspection rights are frequently very extensive in the absence of limits in the operating agreement. If the retiree or transferee is a working member, the purchase price is usually calculated using one of the following formulas:
1. An equivalent amount to the capital account;
2. Fair value vs. fair market value (considering if discounts are permissible);
3. A multiple of earnings; or
4. Another formula for capitalization;
These rules may differ between the minority and the majority.
Expenses incurred in negotiating an operating agreement
If your LLC has only one member, you may establish a business operating agreement without the assistance of a lawyer. Creating an operating agreement is free if you use a service or a tool. If there are multiple members, you should get legal advice. In the United States of America, the cost of engaging an attorney to assist you in creating this agreement might range from an hourly rate to a fee of up to $600.
Consequences of failing to have an operating agreement
Running an LLC without a written operating agreement is very risky. Furthermore, taking the risk would be pointless because it might damage your reputation, result in losses, sever connections, and lead to the dissolution of your organization. Not to mention that your future may be defined by your state’s default laws. The disadvantages are as follows:
Taking a chance on how a court will see your circumstances
Courts may consider an LLC operating agreement when evaluating your limited personal liability. An operating agreement is essential for a single-person LLC because, without one, your LLC would function identically to a sole proprietorship with no limited liability protection. In contrast, if you have a documented operating agreement, the courts may recognize your limited liability status and you have a better chance of avoiding being held accountable for company debts, etc.
Being bound by default state legislation
If no operating agreement is in place and members are unable to reach an agreement, your state will apply the default regulations. In other words, they will pick your company’s terms and conditions and manage any issues on your behalf. As an example, if a firm fails, the members may divide the losses or profits equally without regard to their degree of investment. It’s also a poor resolution if one person contributes more than the other.
There are times when LLC owners and percentage members disagree. However, if you have a business operating agreement, you are prepared to resolve any disagreements and reach amicable agreements on critical matters such as money and profit-sharing, management and decision-making, and what to do when the original members depart. Keep in mind that if you do not create an operating agreement, you will be subject to the default laws of your state. If this happens, there will be a dispute due to state laws.
Finally, and perhaps most importantly, counsel representing the minority must ensure that neither management nor the majority has the capacity to amend the operating agreement to rescind any rights that the minority has successfully acquired. The operating agreement should not be modified without the assent of the minority.
Operating agreements, which are legally binding agreements, are used by limited liability companies (LLCs) to establish the organization’s administration, ownership, and organizational structure. If the company is a multi-member LLC, the operating agreement becomes a legally binding contract between the various members. In addition to specifying ownership and structure, the operating agreement can identify the registered agent, provide meeting times and names of the managers and describe how the firm can add or remove members. To put it simply, the operating agreement specifies a company’s operating and financial choices. When the LLC members sign it, it becomes legally binding on them. One can establish an operating agreement at any time, whether your company is just getting started or is already up and running. When it’s ready, have everyone sign it, create duplicates and keep them securely. It is really beneficial to review the operating agreement every year to verify if it is still relevant to your company’s needs and appropriately reflects the wishes of each member. If your LLC’s operating agreement has to be changed, you must get legal advice. The operating agreement is the primary document that will regulate your LLC during its existence. Negotiating these conditions may be tough, but any disagreements will be significantly more difficult to resolve if your operating agreement is not in place.
Sample of an operating agreement
SINGLE MEMBER OPERATING AGREEMENT
[NAME OF LLC]
A(n) [STATE] Limited Liability Company
THIS OPERATING AGREEMENT (“Agreement”) is made and entered into as of [DATE], on behalf of [NAME OF LLC], a single-member Limited Liability Company (the “Company”) and its sole owner [NAME OF MEMBER] (“Member”) hereby states as follows:
NOW, THEREFORE, for good and valuable consideration, the receipt and sufficiency of which is hereby acknowledged, it is agreed as follows:
1. Formation of LLC.
The Company was formed in [STATE] (“Governing State”), under which the Company filed its Articles of Organization and were made effective on [DATE]. The Company’s operations shall be governed by the terms of this Agreement and the applicable laws of the Governing State relating to the formation, operation, and taxation of an LLC which set out the guidelines and procedures for the formation and operation of an LLC (“Statutes”). To the extent permitted by the Statutes, the terms and provisions of this Agreement shall control in the event there is a conflict between the Statutes and this Agreement.
2. Purposes and Powers.
a) The purposes of the Company shall be:
i. [BUSINESS PURPOSE]; and
ii. To perform or engage in any and all activities and/or businesses for which limited liability companies may be engaged under the Statutes.
b) The Company shall have all powers necessary and convenient to effect any purpose for which it is formed, including all powers granted by the Statutes.
The Company shall continue in existence until dissolved, liquidated, or terminated in accordance with the provisions of this Agreement and, to the extent not otherwise superseded by this Agreement, the Statutes.
4. Registered Office and Resident Agent.
The Registered Office and Resident Agent of the Company shall be as designated in the initial Articles of Organization/Certificate of Organization or any amendment thereof. The Registered Office and/or Resident Agent may be changed from time to time. Any such change shall be made in accordance with the Statutes, or, if different from the Statutes, in accordance with the provisions of this Agreement. If the Resident Agent ever resigns, the Company shall promptly appoint a successor agent.
5. Capital Contributions and Distributions.
The Member may make such capital contributions (each a “Capital Contribution”) in such amounts and at such times as the Member shall determine. The Member shall not be obligated to make any Capital Contributions. The Member may take distributions of the capital from time to time in accordance with the limitations imposed by the Statutes.
6. Books, Records, and Accounting.
a) Books and Records. The Company shall maintain complete and accurate books and records of the Company’s business and affairs as required by the Statutes and such books and records shall be kept at the Company’s Registered Office and shall in all respects be independent of the books, records, and transactions of the Member.
b) Fiscal Year; Accounting. The Company’s fiscal year shall be the calendar year with an ending month of December.
7. Member’s Capital Accounts.
A Capital Account for the Member shall be maintained by the Company. The Member’s Capital Account shall reflect the Member’s capital contributions and increases for any net income or gain of the Company. The Member’s Capital Account shall also reflect decreases for distributions made to the Member and the Member’s share of any losses and deductions of the Company.
8. U.S. Federal / State Income Tax Treatment.
The Member intends that the Company, as a single-member LLC, shall be taxed as a sole proprietorship in accordance with the provisions of the Internal Revenue Code. Any provisions herein that may cause the Company not to be taxed as a sole proprietorship shall be inoperative.
9. Rights, Powers, and Obligations of the Member.
a) Authority. The Member is the sole member of the Company, has sole authority and power to act for or on behalf of the Company, to do any act that would be binding on the Company, or incur any expenditures on behalf of the Company.
b) Liability to Third Parties. The Member shall not be liable for the debts, obligations, or liabilities of the Company, including under a judgment, decree, or order of a court.
c) Rights, Powers, and Obligations of Manager.
The Company is organized as a “member-managed” limited liability company.
The Member is designated as the initial managing member.
d) Ownership of Company Property.
The Company’s assets shall be deemed owned by the Company as an entity, and the Member shall have no ownership interest in such assets or any portion thereof. Title to any or all such Company assets may be held in the name of the Company, one or more nominees, or in “street name,” as the Member may determine.
e) Other Activities.
Except as limited by the Statutes, the Member may engage in other business ventures of any nature, including, without limitation by specification, the ownership of another business similar to that operated by the Company. The Company shall not have any right or interest in any such independent ventures or in the income and profits derived therefrom.
10. Limitation of Liability; Indemnification.
a) Limitation of Liability and Indemnification of Members
i. The Member (including, for purposes of this Section, any estate, heir, personal representative, receiver, trustee, successor, assignee and/or transferee of the Member) shall not be liable, responsible or accountable, in damages or otherwise, to the Company or any other person for: (i) any act performed, or the omission to perform any act, within the scope of the power and authority conferred on the Member by this Agreement and/or by the Statutes except by reason of acts or omissions found by a court of competent jurisdiction upon entry of a final judgment rendered and un-appealable or not timely appealed (“Judicially Determined”) to constitute fraud, gross negligence, recklessness or intentional misconduct; (ii) the termination of the Company and this Agreement pursuant to the terms hereof; (iii) the performance by the Member of, or the omission by the Member to perform, any act which the Member reasonably believed to be consistent with the advice of attorneys, accountants or other professional advisers to the Company with respect to matters relating to the Company, including actions or omissions determined to constitute violations of law but which were not undertaken in bad faith; or (iv) the conduct of any person selected or engaged by the Member.
ii. The Company, its receivers, trustees, successors, assignees, and/or transferees shall indemnify, defend and hold the Member harmless from and against any and all liabilities, damages, losses, costs, and expenses of any nature whatsoever, known or unknown, liquidated or unliquidated, that are incurred by the Member (including amounts paid in satisfaction of judgments, in settlement of any action, suit, demand, investigation, claim or proceeding (“Claim”), as fines or penalties) and from and against all legal or other such costs as well as the expenses of investigating or defending against any Claim or threatened or anticipated Claim arising out of, connected with or relating to this Agreement, the Company or its business affairs in any way; provided, that the conduct of the Member which gave rise to the action against the Member is indemnifiable under the standards set forth in this section.
iii. Upon application, the Member shall be entitled to receive advances to cover the costs of defending or settling any Claim or any threatened or anticipated Claim against the Member that may be subject to indemnification hereunder upon receipt by the Company of any undertaking by or on behalf of the Member to repay such advances to the Company, without interest, if the Member is Judicially Determined not to be entitled to indemnification under this section.
iv. All rights of the Member to indemnification under this section shall (i) be cumulative of, and in addition to, any right to which the Member may be entitled to by contract or as a matter of law or equity, and (ii) survive the dissolution, liquidation or termination of the Company as well as the death, removal, incompetency or insolvency of the Member.
v. The termination of any Claim or threatened Claim against the Member by judgment, order, settlement, or upon a plea of nolo contendere or its equivalent shall not, of itself, cause the Member not to be entitled to indemnification as provided herein unless and until Judicially Determined to not be so entitled.
11. Death, Disability, Dissolution.
a) Death of Member. Upon the death of the Member, the Company shall be dissolved. By separate written documentation, the Member shall designate and appoint the individual who will wind down the Company’s business and transfer or distribute the Member’s Interests and Capital Account as designated by the Member or as may otherwise be required by law.
b) Disability of Member. Upon the disability of a Member, the Member may continue to act as Manager hereunder or appoint a person to so serve until the Member’s Interests and Capital Account of the Member have been transferred or distributed.
c)Dissolution. The Company shall dissolve and its affairs shall be wound up on the first to occur of:
i. At a time or upon the occurrence of an event specified in the Articles of Organization or this Agreement.
ii. The determination by the Member that the Company shall be dissolved.
12. Miscellaneous Provisions.
a) Article Headings. The Article headings and numbers contained in this Agreement have been inserted only as a matter of convenience and for reference and in no way shall be construed to define, limit or describe the scope or intent of any provision of this Agreement.
b) Entire Agreement. This Agreement constitutes the entire agreement between the Member and the Company. This Agreement supersedes any and all other agreements, either oral or written, between said parties with respect to the subject matter hereof.
c) Severability. The invalidity or unenforceability of any particular provision of this Agreement shall not affect the other provisions hereof, and this Agreement shall be construed in all respects as if such invalid or unenforceable provisions were omitted.
d) Amendment. This Agreement may be amended or revoked at any time by a written document executed by the Member.
e) Binding Effect. Subject to the provisions of this Agreement relating to transferability, this Agreement will be binding upon and shall inure to the benefit of the parties, and their respective distributees, heirs, successors, and assigns.
f) Governing Law. This Agreement is being executed and delivered in the Governing State and shall be governed by, construed, and enforced in accordance with the laws of the Governing State.
IN WITNESS WHEREOF, the Member has hereunto set such Member’s hand as of the day and year first above written.
Member’s Signature: ____________________________ Date: _______________
Print Name: ____________________________
ACKNOWLEDGMENT OF NOTARY PUBLIC
STATE OF ______________________
______________________ County, ss.
On this ____ day of ______________________, 20____, before me appeared ______________________, as the Member of this LLC Operating Agreement and who proved to me through government issued photo identification to be the above-named person, in my presence executed foregoing instrument and acknowledged that they executed the same as their free act and deed.
My commission expires: _____________
Frequently Asked Questions (FAQs)
What is the definition of a Limited Liability Company (LLC)?
A limited liability company is a type of private limited business that is notably common in the United States. It is a business structure that combines the limited liability of a corporation with the pass-through taxation of a partnership or sole proprietorship. It is a type of business company that may have one or more owners, who are commonly referred to as ‘members.’
Is a business plan required if I have an LLC operating agreement?
Although a recorded business plan is not legally necessary for an LLC, having one has several advantages. A well-structured business plan is an essential instrument for articulating an organization’s goals and values, as well as providing a logical means of determining whether or not those goals are being reached.
What exactly is an LLC operating agreement?
An LLC Company Document, also known as a Limited Liability Company (LLC) Operating Agreement, is a legal agreement that describes each LLC member’s rights and duties and contains information such as when meetings are conducted, how decisions are made, and how membership is increased.
Is an operating agreement required for a single-member LLC?
According to American law, if you live in one of the six states (California, Delaware, Maine, Missouri, Nebraska, or New York), you must have an operating agreement. Despite having a simpler overall structure than multi-member LLCs, single-member LLCs may encounter situations where having an operating agreement hinders them from dealing with problems.
What must an operating agreement include?
An operating agreement must include provisions for management, voting, membership, and capital contributions.
What is the basic difference between bylaws and operating agreements?
A corporation’s internal rules and regulations are contained in its bylaws. Operating agreements, which outline an LLC’s internal operations, are equivalent. The main difference is that operating agreements are formed for LLCs, whereas bylaws are created for corporations.
Is an operating agreement necessary to be notarized?
It is not necessary to get the operating agreement notarized. Despite the fact that it is not notarized, the document is considered legally binding between the parties. Some firms will still get the signatures notarized to appear more professional.
What format should an operating agreement have?
The simplest way to construct an operating agreement is to use a free operating agreement tool. You may also compose the document in a basic question-and-answer format using such a tool. In general, the interface of such tools is quite simple. The end result is a perfectly drafted operating agreement that may be used for both single-member and multi-member LLCs. If none of these solutions work for you, it is best to consult with a corporate attorney in your state to design this document.
What is the purpose of an operating agreement?
While some jurisdictions require that you have an operating agreement in writing, there are very few, if any, rules that specify what you must do with it once you have it. Your operating agreement should be maintained in the same location as other important company paperwork so that you can simply refer to it or make amendments if necessary.
Can I draft my own operating agreement?
Yes, because operating agreements are not subject to any special legal requirements and do not need to be prepared by a lawyer.
Where should operating agreements be kept?
Operating agreements must be kept in the same place as your company’s important documents. They are not required to be filed with the state.
How much does it cost to create an operating agreement?
If your LLC just has one member, you may establish a business operating agreement without the assistance of a lawyer. If there are several members, you may wish to seek legal guidance to meet the requirements of all members. In the United States of America, the cost of engaging an attorney to assist you in creating this agreement might range from an hourly charge to a fee of up to $600. Creating an operating agreement is free if you use a service or an operating agreement tool online.
Are operating agreements for LLCs legally binding?
Even in states where one is not necessary, an LLC operating agreement is normally considered a legally enforceable instrument once signed. This implies that if members of an LLC ever go to court to settle disputes among themselves or with a third party, the operating agreement’s rules and regulations will very certainly be enforced by the court. Although some organizations choose to have these agreements notarized, it is not required and usually has no effect on the validity or functionality of the agreements.
In an operating agreement, how does ownership appear?
The operating agreement identifies the LLC’s owners as well as their individual ownership holdings. You can, however, assign the ownership in any way you like. Members of an LLC often own a share in proportion to their contributions to the firm’s founding, such as cash investments.
Is a bank account required to make an operating agreement?
An operational agreement may or may not be necessary to create a bank account. This will be determined by the bank’s policies and your state’s legislation. Before opening a business account, you should prepare an operating agreement because most banking sites make it simple and free to do so.
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