User:Immount/Operating agreement

An operating agreement is a key document in the formation of a limited liability company (LLC). An operating agreement can either be written or oral, and once terms have been agreed upon by all members, it serves as an official, binding contract between parties. The agreement outlines the business's financial and functional decisions including rules, regulations, and provisions. This agreement is important because without an operating agreement, an entity intending to operate as an LLC could closely resemble other business entities (sole proprietorships or partnerships) that do not have the liability protections of LLCs. Additionally, the document clarifies how the business will operate and can be referred to in the event of misunderstandings, miscommunications, or conflicts.

To avoid future laborious settlements of dispute, the operating agreement can specify how certain situations are handled before they even arise. Without the agreement, default rules will be applied by the governing state which might not be in the best interest of the parties doing business. These default rules are determined by state statutes or common law. As of late 2021, twenty-two states have enacted the Revised Uniform Limited Liability Company Act (RULLCA) that lays out default rules for LLCs carrying on business without an operating agreement. In Delaware, California, Maine, Missouri, and New York, operating agreements are required by law to carry on business as an LLC.

Typical Terms

An operating agreement typically includes terms that cover members' ownership interest, voting rights and responsibilities, powers and duties of members and managers, distributions, holding meetings, dissociation, and dissolution. However, these topics are not the extent of the terms that can be included in an operating agreement. Any term can be added that is agreed on by all members operating the LLC. This allows for great customization and flexibility of the document and thus the LLC's operations.

Purpose, Powers, and Term

A purpose statement serves as a way for an LLC to outline what activities it can and will engage in. This can be done with a general purpose clause that lets an LLC engage in any activity that is deemed lawful by the governing statute. Alternatively, an operating agreement might include a more limited purpose clause that restricts the company's actions to a specific domain. A more strict purpose statement might limit problems in the future that arise from members having different outlooks for the company's operations.

An LLC's operating agreement power clause highlights the powers the entity has to carry on its business. This statement should explain the powers that will allow the LLC to carry on business that corresponds with the purpose statement. For example. if an LLC has a general purpose statement, then the powers clause should allow for many choices to be made that reflect a broad general purpose. Alternatively, if the LLC's purpose statement limits the company to one domain, the powers clause should also limit the company's powers to be within that domain.

An operating agreement can also specify the length of existence of the business if desired in a term clause. This clause might state that the LLC expires on a certain date or after a set length of time. However, most LLCs do not have this clause and operate until a decided dissolution by the members.

Membership

An operating agreement will list each of the members (the owners of the LLC) involved in the formation of the business entity. Typical membership clauses also state how members can be added to the business after the initial formation. The default rule as defined by the RULLCA is that a member can be added by unanimous decision of all existing members. If the default rule of the state is not desired, any member addition rule can be agreed upon by the parties to amend this.

Along with a member addition clause, LLCs might define different classes of membership in the operating agreement. These membership classes can be important if management rights are to be defined differently for different members. Individual titles for members can be assigned, as well (CEO, CFO, CTO etc.).

Management Type

Two definitions will be utilized throughout this section. A member is defined to be the owner of an LLC, and a manager is a person elected by the members to manage the LLC.

An LLC can elect to be either member-managed or manager-managed in its operating agreement. In a member-managed LLC, each member is also a manager and has rights to manage the business operations of the entity. The RULLCA and most states have the default rule that an LLC is member-managed, and each member has equal managing rights. This can be modified by specifying the rights and responsibilities of each member.

If an LLC chooses to be manager-managed, elected managers will have the rights to manage the business operations and have the implied authority to carry on the ordinary business of the LLC. Typical provisions state that members can elect additional or remove existing managers at any time by a vote of the LLC members.

Voting Rights and Meetings

Another common term in an operating agreement outlines the voting rights of each member. Members may assume that their voting rights are in accordance with their ownership interest, but this is not the case in most jurisdictions unless explicitly stated. An example rule provided by the RULLCA, has that each member shares an equal vote regardless of any other factors, including ownership interest or capital contributions. On the other hand, an LLC might want to elect to distribute voting rights in accordance to a per capital rule that gives each member a vote proportional to their capital contributions to the business.

It is important to outline in an operating agreement what decisions must be determined by a vote and what decisions can be made at the individual discretion of members or managers. An operating agreement might explain how and when meetings are to be held and what proportion of members or managers must be in attendance for any votes to go through. Along with determining voting situations, an operating agreement could outline other events such as quarterly meetings required for all members.

Responsibilities and Powers

Operating agreements can specifically outline the responsibilities and the powers of each of its members and managers. Without this provision, members have equal responsibility and power to manage the operations of the business. A responsibilities and powers term is also important, because an LLC does not want to have to hold a vote for every single decision that is to be made. This clause can lay out exactly what is in the authority of each member of manager. For example, an LLC might want a certain member to be able to make hiring and firing decisions independently while another member can purchase vehicles or other equipment. Writing out this term in an operating agreement can simplify the resolution of disputes about authority in the future.

Member Contributions

A term clarifying how member contributions to the LLC will be handled is also key. Member contributions can come in the form of capital, property, or services. Initial contributions by members generally constitute the formation of the LLC and the contributions are seen as an exchange for ownership interest in the business. This term can outline what the acceptable forms of contribution are, and the events that might cause further capital contributions to be required of the LLC members. It is advised that operating agreements also specify what happens when a member fails to make required or promised contributions to the company. A capital contributions provision could also include lines that outline whether members have the right to withdraw or receive any return from any portion of their capital contributions to the LLC.

Ownership Interest

Operating agreements typically outline the personal property of the LLC that belongs to each of its members, this is called their ownership interest. Generally, ownership interest terms are written using percentages so that as the business appreciates in value, the ownership of the members also appreciates. For example, in a four member LLC, the term might state that each member owns an equal share of 25% of the company. Alternatively, the members might choose to divide ownership interest in proportion to their initial contributions to the LLC or in any other manner that is agreeable to the members.

It is important to note that a member's economic interest can be separated from their management interest. In this case, a member could transfer his or her economic interest to a different person or entity while still maintaining their management and voting rights.

Distributions

As a member of an LLC, one of the most important rights is to receive distributions. These distributions are usually in the form of profits from the operations of the business. A distributions clause could outline exactly how and when distributions will be made to its members. Some clauses might have profits distributed in proportion to each member's ownership interest or current capital accounts records. Alternatively, the term might contain complex rules that allocate profits according to other predetermined factors like how many hours members worked for the LLC or how much revenue a member brought in. Additionally, the timing of distributions can be specified. An LLC could elect to distribute at a certain date each year, when profits break a certain threshold, never, or any other specification agreed on by the members. A further customization could clarify what form the distribution comes in, whether it be cash or other in-kind forms.

It is important to highlight, once again, the flexibility of an operating agreement. The RULLCA, by default, states that members share profits equally regardless of any other factors, but that no member is entitled to a distribution until the dissolution of the company. This might not be desirable, but because an LLC can write its own rules with an operating agreement, this can be avoided.

Dissociation

Dissociation refers to "the change in the relationships among the dissociated member, the company, and the other members caused by a member's ceasing to be associated in the carrying on of the company's business". Dissociation clauses cover when and how members can voluntarily dissociate and should also outline any conditions that constitute forced dissociation of a member. This clause typically clarifies what happens to a member's ownership interest upon departure. It might state that the other members have a buy-out right on the fair value of the ownership interest.

Dissociation clauses are important because they outline what events may trigger the removal of members who are not contribution or are being unreasonable and how these members will be removed.

Dissolution

An operating agreement's dissolution provision highlights when or in what events the company will be dissolved and cease to operate. It will also state what happens with the LLC's assets and liabilities. A dissolution clause might state that an LLC can not dissolve unless there is a certain majority consensus between members in a formal vote. However, without this provision, all members must agree to dissolved the company. Some events that could trigger a dissolution are an expiration of the term of the LLC (if specified), events terminating membership (death, retirement, bankruptcy), and judicial dissolution.

The dissolution clause will lay out how the company's assets are handles after operations cease and who will handle the winding up. The company first must pay back all of its creditors, and then the provision can outline what happens to excess process from the dissolution. This could be distributing the remaining amount in accordance with how the company distributes profits or any other number of specifications including the donation to charity.

Amendments

LLCs often leave clauses in their operating agreements that specify how the agreement is to be modified. This is important as the LLC will develop overtime and new challenges will arise that might not have been handled on the first draft. Typically, this provision will state that all amendments need to be made in writing with the agreement of all members.

Other Provisions

Other popular provisions include what remedies there are for breaching the operating agreement, what happens when there is a conflict between the operating agreement and the articles of organization, or what happens in the event of a split vote. An operating agreement is a flexible document that allows members to personalize the operations of their business. Thus, any desirable other term can be added.