LLC Operating Agreements: Terms and Conditions
This blog post highlights some of the critical issues in negotiating operating agreements for a new business. The operating agreement for a limited liability company (LLC) is the critical document that governs formation, governance, distributions and dissolution of your business, among other issues. You will want to give special attention to negotiating the operating agreement, especially when your business has several partners or investors.
The LLC is a creature of state law based on the agreement of the parties. You have great latitude in negotiating the terms of the operating agreement as most states have few mandatory provisions. The operating agreement is akin to the bylaws for a corporation and addresses similar issues. Like the bylaws for a corporation, you will not file the operating agreement with the department of corporations in your state or here in Washington, D.C., with the Department of Consumer and Regulatory Affairs (DCRA). Although you do not file the operating agreement with the department of corporations, you nevertheless will need one. Even for a simple administrative act like opening a bank account, the bank will ask you for the operating agreement. Your accountant will want to review the agreement when preparing the LLC’s taxes.
We often are asked for a “standard” operating agreement for a startup. Unfortunately, every business is different and your relationship with your other founders or investors may be quite different from other LLCs. As one of the founders of the new business, you can and should narrow the issues as the fewer issues you need to resolve, the easier and less time your startup lawyer will have to spend on drafting the operating agreement. You should keep in mind that your small business attorney will represent the LLC as an entity and not you individually. For larger or more complicated transactions, each member may want to seek separate counsel to make sure that his, her or its interests are being protected.
If you don’t indicate what you want in the operating agreement, you then will have to resolve the issue by reference to the limited liability company law in your specific jurisdiction. Most states contain a provision similar to that of the District of Columbia, which provides that “to the extent the operating agreement does not otherwise provide for a matter described in [this section], this chapter shall govern the matter.” If you don’t want to leave your fate to the LLC law in your jurisdiction, then you should address it in your operating agreement.
In this blog, we outline some of the major issues that you will need to discuss with your partners and investors. For the purposes of this Rosten Law blog post, we assume that you have one or more partners who will be running the business and that you may have one or more outside investors who may or may not be involved with the daily operations of the business.
Name of the business
You won’t be able to file anything until you arrive at a name for your new business. If you have not decided on the name for your new business, you should check out Rosten Law’s article on finding a name for your new business. You should not rush into a name.
LLC taxed as a S corporation or partnership
You should have have already read our articles on the advantages and disadvantages of forming your new business as a corporation versus a LLC. This article covers the terms of an operating agreement, assuming that you have chosen the limited liability company as your corporate form. Even after deciding to organize your business as a LLC, you still need to decide whether to elect to have your new business taxed as a corporation or partnership. And if your startup qualifies for S corp treatment, then you will need to decide whether you should have it taxed as a C corp or S corp.
Forming a New Business: Corporations vs LLCs
Traps for the Unwary: LLC Taxed as S Corp
Investors for Startups: Terms of Engagement
Membership in the LLC
Usually you have a meeting of the minds with your partners on the percentage ownership shares in the LLC. If you have one partner and are running a services firm with no substantial contribution of cash, then likely this issue will not require much negotiation. But if you have investors or unequal contributions, then this issue may require substantial time and energy to resolve. Also, it is not uncommon for a member to want to hold his or her interests in a trust for estate purposes. The other members may object to this arrangement because if the member should die the successor trustee under the trust may not be an ideal partner for the LLC. Similarly, a member may want to hold his or her interests as joint tenants with a spouse and this could create an issue with the remaining members particularly if the member gets a divorce.
Member-managed vs. manager-managed: who makes the decisions?
There are two general approaches to managing LLCs. The first is to have a member-managed LLC under which the management consists of the members of the LLC. The members are involved in the daily management of the LLC. In some states, if you do not address this issue in the operating agreement, the state will treat your LLC as a member-managed LLC. Each member has the authority to bind the LLC.
The second is to have a manager-managed LLC under which the management consists of one or more managers, who may or may not be members in the LLC. The manager or managers may have authority for certain decisions, which you can enumerate in the operating agreement. Usually there are some decisions that are solely within the authority of the members, such as merger or dissolution of the LLC.
Then you may want to address what kind of decisions are reserved to the members and which decisions for the company are reserved to the managers. And there will be decisions that will require unanimous consent either of the members or the managers. If you have two members and managers, then you should be able to come to unanimous agreement. But if you have several managers and outside investors, then there may be occasions when you are unable to reach a unanimous decision. Outside investors also may want to protect their minority rights in the company and may argue for more decisions that require unanimity, essentially giving any member veto authority.
A LLC is a flexible structure and you can make governance of your LLC as close to a corporation or not. For example, if you have outside investors, they may want you to have a board of directors just like a corporation. You may have a requirement for the members to conduct an annual meeting like a shareholders meeting for a corporation. Regardless of whether you have a board of directors, the operating agreement usually addresses how to appoint and remove the LLC’s managers.
Deadlocks: what to do now?
Despite your good intentions, there will come times when you have a deadlock. And especially for those decisions that that require a super majority or unanimity, the more chances you will come to a deadlock. There are various mechanisms to break the deadlock, depending on the nature of the decision to be resolved.
There may be critical decisions that affect the future of the business, for example, a merger or acquisition or a buy-out offer. Some of these mechanisms to resolve deadlocks have great names like Russian roulette, also known as Texas Shoot Out, which allows one member to offer the member’s shares at a specific price to another member, who can either accept the offer or can make the same offer to the member making the original offer and that member must then accept the offer. There are more traditional dispute resolution mechanisms like mediation or arbitration. Some operating agreements address deadlocks with a simple solution: dissolve the company if you can’t agree. Then there is my favorite, a critical decision is resolved by flipping a coin.
Contributions: how much will it cost you and what do you get?
You need to determine how much are you, your partners and investors going to contribute to the LLC and what percentage interests you will each receive. Your contributions may take the form of cash, or it could be property such as intellectual property or machinery, or it could be services. Then you need to decide what each of you receives in exchange for your contribution. In some businesses, the members receive different rights in the LLC. You can receive “economic rights,” which can include the right to share in LLC allocations and distributions. You can also receive certain “non-economic” rights, such as the right to attend meetings and the right to vote on certain issues. If you have investors who want to be protected, they will be keenly interested in these non-economic rights.
Allocation of profit and losses.
If the LLC is taxed as a S corporation, then you do not have the flexibility to create separate classes of stock. But if your LLC is taxed as a partnership you can have very flexible provisions regarding who is entitled to take the profits and losses, even if these allocations are disproportionate to their ownership shares. If you have a member who may have a tax appetite for losses, then you may want to allocate more of the losses to that member. And usually the operating agreement may have a definition of what “net cash flow” means. You should make sure you read that and understand what it means before you agree on allocations.
You need more money: who has to belly up to the bar?
You are running out of working capital or if you have a real estate LLC, you may need money for an investment, but one of your investors doesn’t want to pony up. In negotiating the terms with your partners, pay particular attention to capital calls. Who gets what for the additional capital contribution? In some LLC operating agreements, you will find what is known as a deficit reduction obligation (DRO), which are essentially promises to restore the negative capital account balance if it falls below zero. These may make some (limited) sense in a general partnership agreement, but in a LLC where the members are trying to cap their liability, the members do not want to have unlimited liability for the company’s debts or other obligations in the future. That should be a red flag and you need to tread very carefully when you are negotiating these terms. In some operating agreements, you will find draconian penalties for the failure to make required contributions, such as forfeiture of the membership rights.
Distributions: is it raining or is that a waterfall?
Your company is finally making some money and you have some money to distribute. Your operating agreement will tell you how to distribute excess cash flow. The distribution provisions in your operating agreement are sometimes called the waterfall provisions, and specify how the company will distribute the excess cash flow or other assets to the LLC members. Your lenders will get paid first. And if investors or other members of the LLC have made a loan to the LLC, then they will get paid according to the terms of the loan agreement.
Investors may demand a preferred return. A preferred return allows investors to receive a specified return before the owners receive any return. You will have to agree on what will be the amount of the preferred return and whether the waterfall provision is participating or non-participating in the event of a buy-out. And last but not least, the other members may want to enjoy the fruits of their labor and receive a return on their investment. By contrast with the waterfall negotiated in a private equity investment, the distribution provisions in the LLC agreement for an operating company are frequently relatively simple.
Many operating agreements require some distribution to cover tax liabilities. Remember that if the LLC is taxed as partnership, it is a flow through entity and you could be in a situation where the members have tax liabilities but no distribution to cover those liabilities. Consequently, some operating agreements contain provisions to require distributions at least to cover tax liabilities.
One hotly negotiated point in many operating agreements is what additional incentives to provide management, regardless of whether they are members. You need to decide whether management will be granted profits interests to share in profits of the company. You may not want to give up equity in the business, but you want to provide an incentive for managers of the company to succeed. This may become particularly important in a merger or acquisition of the company. Given the importance of the management team to the success or failure of a buyout, managers usually will receive a management “carry,” incentive compensation to managers in the form of profits interests. This incentive usually vests based on the tenure of the manager with the company or the performance of the company.
Confidentiality and non-compete
You may want an investor, but what if your investor is connected with a competing company. Do you want to have all members, regardless if they are involved in managing the company, to have access to all of the books and records of the LLC? But if you require an investor to sign a non-competition agreement, might the investor walk away from the deal, leaving you without any way to raise enough money to continue? What if your partner decides to leave you and then open up a competing business? These provisions may be the most emotional issues discussed in negotiating an operating agreement.
Dissolution or just plain going out of business
What happens when your partner decides to leave? You have many options including buying him out, but then at what price? Should you be required to close down your business? An operating agreement usually contains provisions regarding what events will cause the dissolution of the company, such as a vote by the members, a government order, or the decision of an arbitrator.
Mergers and acquisitions of LLCs
Creating a LLC is easy, but once you get started and one of the members wants to leave, it can become very challenging especially if you do not have provisions in your operating agreement to guide you on the sale or other transfers of membership rights. Some of these provisions are quite similar to provisions in shareholder agreements for corporations and contain “tag-along” provisions, which allow members with minority interests to benefit from a sale, or “drag-along” provisions, which prevent members holding a minority share from blocking a sale.
Modification of operating agreement
It doesn’t make sense to negotiate all of these provisions and then have the majority of the members vote to modify the operating agreement. Modification of the agreement is usually accomplished through a super majority or unanimous consent of all members. And especially if you have outside investors, they will want assurances that they have a voice if there are any proposed changes.
Negotiating operating agreements: think before you jump
The operating agreement for your LLC is the most important agreement that will govern your business for the life of the business. These terms may be difficult to negotiate but if a dispute arises, they will be even more difficult to resolve without the guidance from your operating agreement. You should go over the terms and conditions of the operating agreement carefully with your small business lawyer and make sure you understand and agree before you jump into a relationship with partners and investors.