Does Your Limited Liability Company Have a “Prenuptial Agreement”? (If Not, Consider Reading This)

With the emergence of the limited liability company (“LLC” or “company”) entity type, an owner, known as a “member,” can minimize or prevent setbacks that interrupt business operations that in very extreme instances, cause it to dissolve.

Similar to a prenuptial agreement in the marriage context, a properly drafted operating agreement can protect members and even the company in the event that a member or members decide to breakup or call it quits.

Below are sections, which at a minimum, should be included in a company’s operating agreement:

1. Formation. A formation section includes information concerning the company’s name, date created, its members, office location, registered agent and ownership. Ownership may be determined either by the percentage or interest that a person has in a company, or by membership units (“units”), which is equivalent to shares of a corporation. If a company has different classes of units, this section should provide detail whether voting rights differ among each class, and if applicable, any distribution waterfalls and preferences describing the ordering of payments among members.
2. Management and Voting. A management and voting section provides information on how a company is managed. It is either “manager-managed” by person(s) appointed by members (a manager may, but is not required to be, a member) or “member-managed,” thus managed by its members. This section should also include provisions regarding how the company conducts official business, such as member voting requirements, resolutions for voting deadlocks, protocols for official meetings including proxy voting, and provisions that specify member authority over company affairs.
3. Capital Contributions. A capital contributions section contains information regarding capital contributions made by members (monetary and non-monetary), the amount, value of contribution (if nonmonetary), and class of units (if applicable) that each member owns, and whether members may be required to make additional capital contributions.
4. Allocation of Profit and Losses and Distributions of Cash. This section explains how company profits and losses are shared among members and other fiscal matters. It may contain information on special allocations, which are non-pro-rata distributions. This section should also discuss how distributions of cash shall be made and whether distributions may be “in kind,” which are payments in the form of a security or property other than cash.
5. Membership Changes. A membership change section describes the process how members are added and removed, if and when members can transfer ownership, and other related provisions. This section should also describe how a company handles a member’s death, bankruptcy of a member, and events that disqualify a person from being a member.
6. Dissolution. A dissolution section provides circumstances when a company may or must be dissolved and steps involved to wind up business affairs.

A properly drafted operating agreement is a critical step to starting a company. Members should invest time in creating this tool which promotes formality and separates a company’s business matters from its owners’ personal matters. Costly attorney fees and litigation expenses can be avoided upfront if an operating agreement is properly drafted.

Consideration should also be given to tax matters by an attorney experienced in that area. The pitfalls of not drafting a timely operating agreement can be costly. Business owners waiting to draft this document when business activity “picks up” may encounter setbacks when a disagreement among members ensues. Discipline and effort should be used to avoid falling into this trap, so make drafting this document a priority when setting up your company.