Take 5: Considerations When Drafting Your LLC Operating Agreement
In a previous entry, we discussed several factors to consider when opening a business, including the type of entity to form. You’ve now taken the step of starting your business and forming a limited liability company (“LLC”). Congratulations! But now you need to determine how your company will be governed. For LLC’s, the rights and responsibilities that govern your company are normally found in the LLC operating agreement. If you are a single-member LLC, the operating agreement is normally a straightforward document. However, if your company has multiple members then it is important to nail down key issues prior to finalizing the operating agreement. Below we’ve identified a few issues to keep in mind. Note, the below assumes there is more than one member of the LLC:
1. Member-Managed or Manager-Managed. One of the foundational decisions when drafting an LLC operating agreement is whether the company will be member-managed or manager-managed. In a member-managed structure, all members actively participate in the decision-making process, similar to a partnership. Conversely, in a manager-managed structure, members appoint one or more managers to oversee day-to-day operations. Choosing the right management structure depends on the nature of the business and the preferences of its members. Member-managed LLCs often work well for small businesses with a hands-on approach from all owners, fostering a sense of unity and shared responsibility. In contrast, manager-managed LLCs are suitable when some members want to take a more strategic, oversight role, while others focus on operational aspects. Additionally, a company founder who wants to bring on partners but retain sole operational control could opt for a manager-managed LLC.
2. Admitting New Members. As businesses evolve, the need to bring in new members may arise. Whether it is due to expansion, the infusion of fresh capital, or the departure of existing members, a well-defined process for admitting new members is crucial. The operating agreement should outline the criteria for admission, such as capital contributions, skills, or industry expertise. Equally important is the determination of the valuation method for the new member's interest in the company. This prevents disputes over the value of the business and ensures transparency and fairness in the admission process. Addressing these considerations in the operating agreement allows for a smooth and well-managed transition when welcoming new members into the LLC.
3. Breaking a Deadlock. In any business venture, disagreements are inevitable. However, when the structure of an LLC requires unanimous or majority decisions, deadlocks can bring operations to a standstill. To avoid such impasses, the operating agreement should outline a clear and fair process for breaking deadlocks. This could involve the appointment of a neutral third party, such as a mediator or arbitrator, to help facilitate resolution. The agreement should also address alternative dispute resolution mechanisms and provide a pathway for dispute escalation if initial attempts fail. By addressing these potential challenges upfront, the operating agreement becomes a proactive tool for conflict resolution, preventing deadlocks from jeopardizing the company's growth and stability.
4. Dissociating or Removing Members. Just as the agreement should provide a framework for admitting new members, it should also establish a clear process for dissociating existing members. Whether it is due to retirement, disagreement, or other reasons, the departure of a member can impact the dynamics of the LLC. The operating agreement should outline the circumstances under which a member can dissociate, as well as the valuation and buyout terms associated with the departing member's interest. By addressing dissociation proactively, the operating agreement minimizes uncertainty and potential disputes, allowing the LLC to navigate member transitions seamlessly. It is type of critical long-term planning that contributes to the stability and continuity of the business.
5. Winding Up. In the event of an LLC's dissolution, the operating agreement should provide a comprehensive plan for winding up the business affairs. This includes the orderly distribution of assets and the settlement of liabilities. The agreement should outline the priorities for repayment, such as paying creditors and distributing remaining assets among members. Additionally, the operating agreement should specify the method for determining the fair market value of assets during the winding-up process. This clarity ensures an equitable distribution of assets and avoids potential disputes among members during the dissolution phase.
This article is meant only as a brief introduction of factors to consider when putting together your LLC operating agreement. If you have specific questions about your LLC operating agreement, or would like assistance with drafting an operating agreement, we’d love to connect!
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