At the heart of an LLC is the “Operating Agreement,” a term that many entrepreneurs have heard but rarely appreciate the importance of. LLC’s are a hybrid combination of a partnership and a corporation. They are a creature of contract that allows for the unique circumstances that they were created to serve. Simply put, it is an agreement that can be structured to reflect the unique negotiations of “the deal”. The Operating Agreement provides flexibility to translate those deal terms into a business framework.
In most jurisdictions, the Operating Agreements is one of the few statutorily imposed requirements that a LLC must
observe (Section 608.407 of the Florida LLC Act), (Section 417 of the New York LLC Act). And while an LLC Act provides some default terms on how the LLC should operate, it is a limited generic baseline and in many instances may run contrary to the understanding of the partners. It is imperative for the members to take the time to have a properly crafted Operating Agreement to reflect their unique relationship.
The following is a summary breakdown of some of the most critical Operating Agreement provisions.
• Ownership Interests
• Purpose
• Allocation and Distribution of Profits and Losses
• Special Duties and Restrictions
• Voting Rights and Mechanics
• Managers
• Admission of New Members; Transfer of Membership
• Meetings
• Dissolution of the Company
One of the most overlooked functions of the Operating Agreement is to set forth the actual ownership interest that the members have in the LLC. This is commonly achieved by a “Schedule” attached to the Operating Agreement that lists the member names, the initial amount of capital they invested, the nature of the investment i.e. capital or labor and the percentage interest each member owns in the LLC. Unlike a corporation that has share certificates evidencing ownership, LLC’s can and often do rely on the schedule in the Operating Agreement to set forth the relative interests of the members.
Unlike a corporation, the equity a member has in the LLC and the amount of profits or losses that member is entitled to receive can be different. In contrast, in a corporation, a 50% shareholder would usually receive 50% of the profits of the corporation automatically. However, in an LLC, a member with a 50% Membership Interest could be configured to receive only 10% of the LLC’s profits/losses, which is something that can be specified in the Operating Agreement.
This allows for various creative structures to incentivize and facilitate a variety of deals.
The Operating Agreement may address the unique arrangements between the members or between the members and the LLC. For example, members may be obligated to work for the LLC on a full time basis (or the reverse, the members may be expressly permitted to work in and for other ventures). In addition, the Operating Agreement may provide for a member “Non-Compete” during and after membership in the LLC. Confidentiality and fiduciary obligations may also be required of the members during and after membership in the LLC. These provisions can all carry penalties for breach, including expulsion, reduction in membership interest, etc.
One of the core functions of an Operating Agreement is to set out the mechanics and restrictions for the transfer of equity member’s ownership interests. One of the common approaches is the so called “right of first refusal” which grants the LLC and other members the opportunity to match any offer obtained from any third party by a member wishing to sell his or her Membership Interest. In addition, the Operating Agreement can address so called “involuntary transfer” situations such as death, bankruptcy, disability or termination of employment by the company, as triggers that require a Member to sell, or the LLC to buy, a Membership Interest. In these situations, the Operating Agreement should also lay out a procedure and formula for determining valuation and buyout.
Summary. An Operating Agreement is an essential LLC component. In the short term, developing one will assist the partners in identifying and articulating their particular concerns. In the long term, an Operating Agreement will be the reference guide for many if not all of the scenarios that may impact the partners’ relationship.
Sidney Turner
www.SidneyTurnerLLC.com
