Setting up an LLC is relatively straightforward. You may have been pleasantly surprised at how easy it was to prepare your Articles of Organization and form the company. But, figuring out how your new business is going to operate can be a little trickier. That’s where the LLC’s Operating Agreement comes in.
Why You Want an LLC Operating Agreement
The Operating Agreement defines the internal rules for the company, such as: who’s responsible for what, how decisions will be made, how profits and losses will be split, and what happens if someone wants out. No state requires an LLC to have an Operating Agreement. Yet, it’s an essential document for every LLC, no matter how small the business or how it’s managed. The Operating Agreement is the only document that governs how the LLC will be managed and run. If you don’t put together an Operating Agreement, the LLC will be governed by the state’s default rules — and those default provisions may or may not work for your situation.
What Goes In an LLC Operating Agreement?
Hammering out the details upfront while preparing the Operating Agreement is a great way to prevent conflicts and misunderstandings among owners. Here are five things to consider when writing yours:
1. How Should the LLC Be Managed
An LLC can either be member-managed or manager-managed. Member-managed means that co-owners/members run the business on a daily basis. The members are actively making decisions, running the company, selling goods, etc. on a daily basis. With manager-managed, the LLC delegates authority to a President, Treasurer or other officers. This is similar to a corporation with a board of directors. In most states, if you don’t specify the management structure in the Operating Agreement, your LLC will be member-managed by default.
2. How Should Decisions Be Made
In many states, the default provisions for LLCs specify that voting power is proportional to ownership percentage. This arrangement may or may not suit your business. For example, if you start an LLC with a partner, it may make sense to have equal voting rights, or to give all the decision-making authority to one person. You can even stipulate that day-to-day operational decisions can be made by one person, but that major company decisions (such as selling the company or buying another business) require unanimous agreement. If there is an even number of owners/members in the LLC and everyone is given one equal vote, be sure to define what happens when there’s a tie.
3. How Should Profits Be Split
With a corporation, profits are always allocated based on ownership; if you own 50 percent of the business, you’ll get 50 percent of the profits that are distributed at the end of the year. However, the LLC offers more flexibility; owners/members can divvy up the excess profits however they like, regardless of initial investment or ownership ratio. For example, let’s say you form an LLC with a friend. You contribute an equal amount of investment upfront and share ownership 50-50. However, for the first two years, you’re doing the bulk of the work, while your friend has other commitments. In this case, you can agree that you should get 75 percent of the extra profits for the first two years.
4. What Happens If Someone Wants to Sell
It’s hard to predict what the future will bring and there may come a time when one of your partners (another LLC member) wants to sell his or her interest in the company. If rules aren’t specified in the Operating Agreement, then he or she is free to sell, leaving you with a brand new partner whom you may not be comfortable working with.
You can create some restrictions in the Operating Agreement to avoid this scenario. One option is to restrict selling one’s interest unless a specified majority of members approve. You could also add in a right of first refusal clause, where a member needs to offer the same deal/terms to other LLC members before making the deal with a third party.
5. What If Someone Wants Out
A member might choose to leave for personal reasons (e.g. they need to move for family reasons). They could also pass away, get divorced or run into personal financial trouble and file for personal bankruptcy. These aren’t pleasant things to think about, but it can be easier to write out the rules ahead of time instead of having to figure things out as situations occur and emotions run high.
For example, if someone wants to leave voluntarily, you can stipulate that they need to offer their ownership interest to the other owners first, before finding another buyer. If a member passes away, you can specify the transfer to a third party requires the approval of other members. If a member files for bankruptcy, you could define that the LLC should purchase their entire membership interest (to ensure their financial troubles don’t affect the business). And, should a member get a divorce, you can specify that the LLC members have the right to purchase the membership interest of the divorcing member (to make sure the divorcing member’s spouse isn’t entitled to 50 percent of their shares).
The bottom line is that the LLC gives you a lot of flexibility in terms of how you want your business to operate. Spend a little time upfront to think about the specifics. Your Operating Agreement can be just a few pages (and you can even find some samples on the Web). It’s an important document to clarify verbal agreements and prevent costly misunderstandings down the road.
Lastly, the Operating Agreement is a living document; don’t forget to update it as things change. For example, from time to time, members’ roles and responsibilities in the company will change; you may change how profits are allocated; or you may change the company address. Your LLC should always reflect your current situation. So for those of you who have an existing Operating Agreement, the end of year is a perfect opportunity to bring it up to date.
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