Many business owners think it’s easy to set up an LLC. That’s partly the result of companies and websites that claim to offer simple, “standardized” LLC operating agreements. Just fill in the blanks and you’re off!
In reality, there’s no such thing as a “standard” LLC operating agreement. You have a lot of choices to make, and even if you’re starting a very simple business, your choices will have a profound effect on you down the road if the business takes off.
Unlike a traditional corporation, an LLC is designed to be very flexible and give you a lot of options. But unless you specify an option, you may be stuck with a legal “default” rule that you never considered and that isn’t to your advantage. This could lead to problems that are very difficult and costly to resolve.
Here’s a very brief list of things to consider (among many others):
Ownership percentage. The most common way to divide ownership is in proportion to the capital contributed by the members, but this might not make the most sense. For example, what if one member contributes in the form of services or plays a greater role in operations?
Management. Who will be in charge and make operating decisions? What types of decisions will be left to a manager, and what types will be subject to a member vote? If there’s a vote, will it be by a majority of the members, a majority of the percentage interest, or a majority of those in attendance? Should a two-thirds or other super-majority be necessary for certain important decisions? If so, which ones?
Voting rights. An LLC can assign different voting rights to members. A person with a 10% membership interest could have a 30% voting interest, for instance, while other “passive” members could have no voting interest. Or one or more members could have a veto power over certain decisions.
Be careful: A lot of “form” LLC agreements require 100% of members to constitute a quorum – which means that a disgruntled owner could stymie a vote on an important matter simply by not showing up at a meeting.
Representations and warranties. Are the members making promises about what they’re bringing to the table, for which they can be held legally responsible?
Profits and losses. How will these be distributed to the members? Will profits be distributed on a regular basis, such as quarterly, or at will? If they’re distributed at will, who will decide? If they’re distributed on a regular basis, how will it be determined how much should be distributed and how much should be retained as operating capital?
Taxes. LLCs don’t pay taxes; the members do. But because the operating agreement determines how income and losses are allocated for tax purposes, these provisions are very important. As an example: Some people who receive an LLC interest in return for providing services are surprised to discover that, under the agreement, the LLC interest is taxable to them. And some people are surprised to discover that they owe taxes on an LLC’s undistributed profits.
Accounting. What method of accounting will you use? What will be your fiscal year? What rights will the members have to inspect the books and have them audited?
Capital calls. What are the rules if the LLC needs more cash from the members?
New members. What are the provisions for bringing in a new member? Is there a way that current members can prevent the dilution of their ownership or voting share?
Member withdrawal. What happens if a member wants to leave, or cash out? Must the member sell his or her interest to the other owners, or can it be sold to a third party? If it can be sold to a third party, must the other members approve the sale? Can they have a right of first refusal? If the withdrawing member had management rights, can the sale exclude those rights? Must the departing member sign a non-compete or confidentiality agreement?
You might also want to limit the members’ ability to use their LLC interest as collateral, since a foreclosure could result in an involuntary withdrawal – and an unwanted new member.
Buyouts. Can a member be forced out? How, and under what circumstances? For instance, a buyout may be mandated if a member dies, becomes disabled, files bankruptcy, or is terminated by the business. Also, how will the value of the member’s share be determined for buyout purposes?
Disputes. You might want to provide that any disputes among members must be settled by mediation and/or arbitration.
Amendments. If the operating agreement needs to be changed later, what is the process for this? You want to make the amendment provisions as friendly as possible. Beware: some “form” agreements and state default rules say that an agreement can’t be altered without the consent of all the members.
Dissolution. If you need to dissolve the LLC, you’ll want a rule that says how a dissolution vote will be taken and how the LLC assets will be divided up. Not having such a provision can lead to nasty disputes if things don’t work out.
As you can see, simply using a “standard” LLC agreement without considering all the issues with an attorney can be a recipe for disaster down the road.