What Should Be Included in LLC Operating Agreements? Part II

What Should Be Included in LLC Operating Agreements? Part II

 As I said in my recent post about LLCs, the internal governance of LLCs is largely determined by contract among the LLC members. This contract, called an operating agreement, is the centerpiece of each LLC. I strongly recommend every multi-member LLC to have a written operating agreement.

The core elements of an LLC operating agreement include provisions relating to equity structure (contributions, capital accounts, allocations of profits, losses and distributions), management, voting, limitation on liability and indemnification, books and records, anti-dilution protections, if any, restrictions on transfer, buyouts, dissolution and liquidation, confidentiality and restrictive covenants, and general provisions such as governing law and dispute resolution. Let's quickly review them.

Equity Structure

(a) Membership Interest. A member’s membership interest is often expressed as a percentage interest. It can vary as new members are added. It is also important to remember that membership interest is comprised of two components: (i) an economic interest and (ii) a management interest. Often, membership interest is expressed in units to give LLC’s equity more of the look and feel of stock. Some LLCs even refer to their units as “shares” and have an authorized and issued number of shares, just like in a corporation.

(b) Classes of Membership Interests. Given the flexible capital structure of LLCs, it is possible to create the equivalents of equity structures of partnerships or corporations. An LLC can have non-voting interests, common interests, preferred interests, convertible interests, profits interests, etc.

(c) Contributions and Capital Accounts. Each member has a capital account. Initial percentage interests are determined based upon value given to initial capital contributions. A member's capital contribution to the LLC may take the form of cash, property, services rendered, a promissory note, or some other obligation to contribute cash or property or to render services, or any combination of the foregoing. If a member contributes property or something other than cash, the value of such contribution often gets negotiated. Also, members need to address in the operating agreement whether there will only be initial capital contributions, or whether members will be asked to make ongoing contributions or there will be potential future capital calls.

(d) Allocation of Profits, Losses, and Distributions. The operating agreement may alter the default rule of proportionate allocation of profits, losses, and distributions among members. The operating agreement may provide each class of units with unique economic rights and may even alter the allocation rules between members of the same class. It is possible, for example, for a member that holds 50% of percentage interest in an LLC to be allocated 100% of the LLC’s profits or losses in a given year or to receive preferred returns.

Management

An LLC may be managed by members or managers. If LLC is manager-managed, this section of the operating agreement would describe the appointment of managers (which members may appoint), the nature and frequency of manager meetings and voting procedures, duties and responsibilities of managers, term, and procedures for manager removal and replacement.

Voting

The operating agreement may alter the standard rule that members vote in proportion to their percentage interests.  It can even withhold entirely the voting right of a member or class of members to vote upon any matter. Voting rights can also be determined on the basis of capital contributions, capital commitments or capital accounts. Also, certain members or managers can have veto rights or supermajority votes. For example, a class may not have general voting or managerial rights, but have veto right on certain actions to be taken by the managers.

Limitation on Liability, Indemnification

This section deals with fiduciary duties of the managers. There have been interesting legal developments in this area, and I would like to discuss it in a separate blog post.

Books and Records

This section is self-explanatory. It addresses record keeping and the rights of members to inspect corporate and accounting records of the company.

Anti-dilution Protections

The anti-dilution provisions allow a member to maintain its membership interest percentage in the case when the LLC issues membership interests to new members. Such protections may include: a veto right on new issuance of membership interests and admission of new members; limitation on capital calls (for example, no additional capital calls without consent of all members); and pre-emptive rights that allow a member to purchase any class of membership interest being offered in order to maintain their percentage interest.

Restrictions on Transfer

(a) Assignability of Interests.  Frequently, a membership interest can be assigned, but such assignment does not include management rights. To transfer both the economic and management rights of a membership interest, a member needs to comply with restrictions on transfer and (if the operating agreement so provides) obtain the managers’ consent.

(i) Veto / approval rights. Transfer of a membership interest can require the consent of all members or all managers or a certain percentage thereof.

(ii) Right of first refusal. The company and/or other members receive the right within a set period of time to match the offer of a third party for another member’s membership interest.

(iii) Permitted transfers. Members can agree to carve out certain transactions from the restrictions on transfer, such as transfers to affiliates and / or for estate planning purposes.

(b) Buyout. Certain events (such as death, disability, bankruptcy, termination of employment) can give an option to the company or other members to buy out such member (or a right to the member to be bought out by the company or other members). If the operating agreement has buyout provisions, it is important to describe the procedure of how such buyout will take place, the buyout price and the payout terms (can be over time or perhaps from the proceeds of a key man life insurance).

It may be difficult to determine the buyout price, especially for smaller, pre-revenue LLCs.  There is a lot of room for creativity here.  Sometimes, members agree on a certain fixed price ahead of time. Other times, the price will equal to the fair market value, to be determined by one or more appraisers.

(c) Tag Along and Drag Along Rights.  The tag along rights protect minority members from being left behind upon the sale of a majority member’s interest, whereas the drag along rights assist majority member(s) in packaging all membership interests to facilitate full equity sale of the company.

Confidentiality and restrictive covenants include provisions such as non-compete and non-solicit.

Liquidation and dissolution

This section specifies who determines when to dissolve an LLC or what events can trigger dissolution. There are also winding up procedures and a waterfall of distributions of LLC’s assets upon dissolution.

General provisions

Last but not least, the general provisions can include a provision requiring members to settle disputes first through non-binding mediation, followed by binding arbitration. There should also be a provision regarding required vote to amend the operating agreement (perhaps, a vote by managers and a certain percentage of members). There may also be a “adverse affect” proviso, requiring consent of each member who is adversely affected by such amendment if such amendment relates to the limited liability of such member, or it adversely alters its interest in profits, losses or distributions (other than as a result of admission of additional members).

As you can see, an LLC operating agreement is a complex document that often reaches 30+ pages. It is also a “living” document that should be amended as the needs of the LLC change. A meaningful operating agreement that provides the means to address various situations is a key to success in operating a limited liability company.

Read more commentary from Arina Shulga on the legal aspects of operating new and growing businesses at Business Law Post.

This article is not a legal advice, and was written for general informational purposes only.

For more information about LexisNexis products and solutions connect with us through our corporate site.