An important step in the forming a limited liability company (LLC) is the creation of an operating agreement between all of the LLC’s initial members. Although most states permit an oral operating agreement, having an oral agreement with regards to critical business decisions—including voting rights and exiting the business—is extremely unwise. Therefore, even if an oral agreement is permitted, the initial members should draft and execute a written operating agreement.
CT Tip: Although the operating agreement is adopted after the state accepts the LLC’s formation documents—including the appointment of a registered agent—the actual creation of the document should start will in advance of the official filing. Indeed, drafting the agreement may surface significant differences among the owners that should be resolved before the filing the articles of organization.
Although drafting an agreement can be time-consuming, if there is more than one member, the time invested in working out the details of the business structure will be extraordinarily beneficial over time. And, it is crucial to understand: Anything not stated in the articles of organization and the operating agreement will be governed by the default statutory LLC laws adopted by the state. What’s more, if the state statutes are amended—you may find yourself subject to very different rules than the ones that applied when you filed the articles of organization for your LLC. In many cases, these default provisions may not match the desires or meet the needs of the members.
The following essential areas are typically addressed by the LLC operating agreement.
What are the classes of members within the LLC? Generally, an LLC does not describe the different types of ownership interests in its articles of organization. Instead, this is accomplished in the LLC's operating agreement. (Note that some founders prefer to state classes of ownership in the articles of incorporation as a form of public notice regarding the ownership structure of the LLC. However, this means that a modification to the classes of members will require a filing with the state, which is not required for changes in the operating agreement.)
Who will manage the company? In most states, an LLC is member-managed by default. This can prove cumbersome as all members must vote on all decisions—not simply major ones, such as a merger. It can also prove risky from an asset protection standpoint as any member can bind the company and failing to have all members agree can put the liability shield in jeopardy. The line of demarcation between manager and members (the scope of the manager’s duties and authority) should be spelled out, as should the extent of the liability of managers.
How are profits, losses and tax items allocated among the members? The usual statutory presumption is that all of the owners hold voting interests and divide profits and losses according to their relative ownership interests. Many times, the owners will modify each of these default rules as an incentive for investment, for tax planning and for succession planning. The modification can provide that these rights are based on contributions, rather than shared equally, or based upon any other standards acceptable to the members.
Other important areas that are generally covered in the LLC operating agreement include:
- When are member votes required to take actions, such as electing or removing managers if any, and entering into mergers
- How will new members be admitted and current members allowed to withdraw.
- When and how the LLC will be dissolved.
The importance of a well-crafted operating agreement—which will include rules for amending the agreement—cannot be overstated. Failure to have an agreement leaves the LLC and its members at the mercy of state statutes, which are often vague or confusing and can change at any point.