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 | LLC Operating Agreement Information This information about LLCs is presented for educational purposes only. We suggest you talk to your attorney or accountant to see if this information would be beneficial to you and your business needs | |||||||
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LIMITED LIABILITY COMPANY OPERATING AGREEMENT The term Operating Agreement is the name given to an agreement between the members (owners) and managers of a LLC (limited liability company) that sets forth their rights and obligations with respect to the company. It is the limited liability company equivalent to a partnership's partnership agreement or a corporation's stockholder's agreement, and governs the relations among the members and the managers, and between the members and managers and the company Operating Agreement Provisions Can an LLC Operate Without an Operating Agreement? What are the Major Issues to be Included in an Operating Agreement? Note: An Operating Agreement can alter the general rule and make it easier or harder to admit new members. For example, the Operating Agreement might prohibit the manager(s) from identifying new members without the prior consent of all of the members or a majority of the members, or it may allow a prospective member to become a member with the consent of a majority of the members or all of the members. 2. Restrict Members from Freely Transferring Their Interests in the Company: The Operating Agreement can prohibit members from transferring or encumbering all or any portion of their interests in the company. The Operating Agreement should contain explicit rules with respect to how and when members can transfer their interests in the company. If the company does not have an Operating Agreement that prohibits members from transferring their interests in the company, the Act provides that a member may assign the member's interest, in whole or in part at any time. The mere assignment of an interest in a limited liability company does not entitle the assignee to participate in the management of the business and affairs of the limited liability company, or to become or to exercise the rights of a member, unless the assignee is admitted as a member. Note: Without a provision in an Operating Agreement prohibiting a member from assigning the member's interest in the company, any member may assign the member's right to receive profits, losses and distributions of money from the company. Without an Operating Agreement that prohibits unrestricted transfers of membership interests, a member could wake up one day and find that an unwanted or undesirable person or entity has an interest in the company. 3. Right of First Refusal on Transfers of Interests: The Operating Agreement can provide that a member who desires to sell or dispose of the member's interest in the company must first notify the company and the other members of the terms and conditions of a proposed sale and give the company and other members the option to purchase the interest on the same terms and conditions it is offered to a prospective buyer. Note: The right of first refusal is a mechanism that allows the members of a limited liability company to retain control of all ownership interests in the company. For example, if three people form a limited liability company that depends on the members working together closely as a team and if one person wants to dispose of his or her interest, the right of first refusal allows the original members to acquire the interests of the departing member and prevent the departing member from transferring his or her interest to a person that might not be compatible with the continuing members or that could create problems for the continuing members. 4. Rights to Purchase the Interest of a Member: Situations may arise (Triggering Events ) that give the company and its members an option to purchase a member's interest in the company. Examples of Triggering Events include: (1) death, (2) bankruptcy, (3) insanity or incompetence, (4) conviction of a felony, (5) involvement in an activity that harms the business or reputation of the company, (6) failure to make a capital contribution, (7) termination of employment if employed by the company, (8) divorce where the inactive spouse obtains the interest of the active spouse in a property settlement, and (9) a member's default of any obligation owed by the member to the company. Note: A problem member can jeopardize the profitability and/or survivability of a limited liability company. An Operating Agreement that gives the company and members an option to purchase the interest of a problem member allows the members to obtain a divorce from the problem member. Would you like to continue to be in business with a member who failed to make a capital contribution, inherited the membership from his deceased father-in-law, was convicted of theft or a violent crime, or was operating a business that competes with the business of the company? 5. Set Rules for Allocation of Profits and Losses. Without an Operating Agreement, profits are allocated among the members according to the manner in which they share in distributions that exceed the repayment of their capital contributions and losses are allocated according to the relative capital contributions that members have made or promised to make in the future. Note: This provision means that if two people form a company and one contributes $100 and the other is to contribute nothing, the two members must then split future profits equally unless they agree in an Operating Agreement to allocate the profits differently. If the members of your company intend to allocate profits other than equally to all members, that agreement must be in writing to be enforceable. 6. Set Rules for Distributions of Money. Without an Operating Agreement, distributions of cash or other property to members must be shared among the members in the following order: Note: This provision means that if two people form a company and one contributes $100 and the other is to contribute nothing, the member who contributes the $100 is entitled to ALL distributions until the member gets the $100 back. When the money member receives all of the $100, the two members must then split future distributions equally. Most of the time members intend to split the distributions according to a fixed percentage among members from day one despite the fact one or more members has not received distributions of all of their capital. If you do not intend to be governed by the general rule, your company needs an Operating Agreement that specifies how profits, losses and distributions will be allocated among the members before and after they receive all their capital contributions. 7. Company Governance Rules. State Acts usually stipulates that a company may not take any of the following actions without the affirmative vote, approval or consent of a majority of the members: Note: The general rule is that the company cannot make distributions of money to members without the proper consent. An Operating Agreement can specify when money can be distributed and the amount of distributions plus address all of the other governance issues set forth above. 8. Restrict the Right of a Member or Manager to Contract with the Company: Except as provided in an Operating Agreement, a member or manager may lend money to and transact other business with a limited liability company and, subject to other applicable law, has the same rights and obligations with respect to those transactions as a person who is not a member or manager. Note: Without restrictions in an Operating Agreement, a manger of a company may cause the company to enter into a legally binding agreement with the manager, the manager's relatives and affiliates, or any person or entity. Members may want to require prior consent of a majority of the members or all of the members before a manager or member may loan money to the company, enter into an agreement with the company, or cause the company to enter into any agreement with a family member or affiliate of a member or manager. 9. Obligate Members to Pay Money to the Company: A member is not obligated to contribute money or property or make a capital contribution to a limited liability company unless the member agrees to do so in a written document signed by the member. Note: If your company's cash flow needs require that each member contribute $5,000 to the company for three years to make payments due on the company's purchase of real property, the members will not be obligated to make the payments unless their obligations are contained in a written document. An Operating Agreement may provide that one or more members are obligated to pay money to the company when it is formed, on specific future dates or if the company lacks cash to pay its debts. This type of provision can prevent an economic disaster during times when the company has cash flow problems or suffers losses. Without a written promise to pay, members may ignore their obligations to pay money when needed. The Operating Agreement could provide that a member who defaults on an obligation to pay money to the company could be required to sell the member's interest in the company to the other members or to the company. 10. Restrict the Company's Right to Borrow and Loan Money: the Acts of most States authorize a limited liability company to borrow and lend money to members and others, and these powers are to be broadly construed. Managers of the company have the apparent authority to cause the company to borrow or loan money to or from members and third parties. Note: Members may agree in an Operating Agreement on when the company may borrow or loan money, whether loans can involve other members or third parties, the general terms and conditions applicable to a loan (such as the interest rate) and the maximum amount of a loan. It is very common for members to agree in an Operating Agreement that the company may or may not borrow from or lend to other members or that loans involving more than a specified amount cannot be made with the prior approval of a majority of the members or all of the members. 11. Terminate a Member's Interest in the Company: An Operating Agreement may provide circumstances that give the company an option to expel a member and terminate the member's entire interest in the company. Without explicit terms and conditions in an Operating Agreement that provide for the expulsion of a member, it may be difficult or impossible to terminate the interest of a problem member. Note: Expulsion provisions in an Operating Agreement can be used to oust a problem member from the company. This type of provision is most commonly used in an Operating Agreement in connection with obligations to pay money, but it can also apply in any situation where a member defaults on an obligation owed to the company. If a member is obligated to pay money to the company and fails to do so, an Operating Agreement can provide that the defaulting member forfeits voting and management rights, is liable for damages and that the member's interest in the company be purchased with the result that the member ceases to be a member. 12. Restrict the Right of a Member to Withdraw from the Company: The Act authorizes a member to withdraw from a limited liability company at any time on mailing or delivering written notice of withdrawal to the other members. An Operating Agreement can restrict a member's right to withdraw from the company. Note: Usually it is not in the best interest of the company or its members if a member may withdraw as a member at any time. By including a restriction on members' rights to unilaterally withdraw from membership in the company, the limited liability company may recover from the withdrawing member damages for breach of the Operating Agreement and offset the damages against any amount otherwise distributable to the withdrawing member. Does the law require that a limited liability company have an Operating Agreement? Does the law require that an Operating Agreement contain any specific provisions? Does the law require that Operating Agreements be in writing? Does the law require an Operating Agreement be written by an attorney? | ||||
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