Key Considerations in Creating an LLC Operating Agreement

You’ve decided to form a limited liability company (LLC) for your new business venture – congratulations. Now you must make a few key decisions about the LLC, such as choosing the state of formation and filing to register your entity. As we discussed in an earlier post, another basic step in the formation process is drafting an operating agreement (also known as an LLC agreement) which will include important provisions relating to the management and ownership of the business.

Adopting an operating agreement is not a legal requirement in every state. However, if an LLC will have more than one member, this agreement is highly recommended in order to establish clear expectations around the rights and obligations of each member as they relate to the LLC and its operation. If your LLC will have more than one member, the following key issues should be considered when drafting the operating agreement:

        1. Management and Control

Deciding how the LLC will be managed is a pivotal consideration. It can be either member-managed or manager-managed. If you choose a manager-managed model, will you have just one manager or a board of managers? Likewise, if the LLC will be member-managed, will one member be responsible for managing the company, or will all members play an equal role?

Once the model is selected, the next step is determining the scope of management’s decision-making authority. Typically, day-to-day control over the general operations of the company is given to management, while more mission-critical actions such as dissolving the company will require member approval. Additionally, the LLC agreement may address (a) procedures management is expected to follow in performance of its duties, (b) compensation for management (if any), (c) management’s ability to delegate authority to certain officers of the company, and (d) management indemnity provisions.

Finally, will there be different classes of membership with different rights? For example, members can be distinguished by their right to vote (voting and non-voting members) and/or their right to receive profit distributions. Given the significance of these decisions, each member should be advised to seek review of the operating agreement by their own legal counsel. This practice can help prevent any misconceptions by members and delays in executing the agreement.

2. Capital Contributions

Each member is usually required to make a capital contribution to the LLC in exchange for an ownership share in the company. This contribution may come in the form of cash, assets or a member’s prospective “sweat equity” in the business, or a combination of these. The percentage of ownership each member receives in return is often negotiated among the members; it is not necessarily pro rata to the amount of the member’s capital contribution. A capital account will be maintained for each member, reflecting the value of their contribution, and the operating agreement should include a schedule which sets forth the names of the members, their respective capital contributions and their percentages of ownership.

If desired by the members, the LLC agreement also can include a capital call provision by which additional capital contributions can be required of members in the future, sometimes at the behest of management. This clause is normally used to raise capital in support of the company’s growth (i.e., to cover expanding operational costs or to fund a specific transaction such as an acquisition). A capital call provision requires consideration of many issues, including the specific procedures to be followed when making the call and how to handle defaulting members.

3. Allocation of Profits and Losses; Distributions

Allocation provisions address the relative economics of the LLC, including how profits and losses will be allocated among the members in each of their capital accounts. Your accountant or tax advisor should review the LLC agreement’s P&L provisions with an eye toward their tax implications. It is worth noting that most LLC agreements will address tax issues, as well as books and records requirements, in a separate, designated section of the agreement.

Meanwhile, the distribution provisions will control how profits are actually distributed to members, including when and how. Distributions are normally left to the discretion of management or tied to the occurrence of certain events, or a combination of both. Distributions will reduce a member’s capital account by the amount of the actual distribution.

4. Ownership Transfer

Transfer provisions are sometimes the most difficult for members to agree upon, and as a result, they can take a variety of forms. In most LLC agreements, the sale or other transfer of a member’s LLC interests requires company approval, either by action of management or by some percentage of the members, unless the transfer is specifically permitted under the terms of the operating agreement.

Depending upon the relative complexity of the transaction underlying the LLC’s creation, this section may include such transfer concepts as rights of first refusal, rights of first offer, drag-along rights, tag-along rights, buy-sell provisions (put and call rights), and pre-emptive rights – basically, rights commonly addressed in a corporation’s shareholder agreement or voting agreement.

5. Dissolution; Winding Up

All operating agreements should address the possible dissolution of the company, including decision-making authority, permissible reasons allowing for a dissolution, and the process by which the dissolution will occur. The decision to dissolve is generally made by the members, although the courts can also mandate it (known as a “judicial dissolution”). Dissolution can also be predicated upon such triggering events as the sale of the company’s assets or its relocation to and reincorporation under another jurisdiction.

The agreement will also provide a roadmap for the actual unwinding of the business. For example, settling the company’s liabilities and obligations, dealing with any remaining assets, and shutting down operations are all post-dissolution tasks. In most cases, management (or its designees) are empowered to take all necessary steps to accomplish these tasks. Finally, the dissolution provisions will specify the order in which creditors and members are to receive what is left of the business – the so-called “dissolution waterfall.” Following payments to creditors, members will typically split anything remaining based upon and in proportion to their respective capital accounts.

Clearly, there is no one-size-fits-all approach to drafting an operating agreement. Instead, the core issues discussed here are intended to serve as a guide to creating an agreement that not only reflects the vision of the LLC’s founding members, but also addresses the specific operational needs of the business. Although the jurisdiction of formation may impose its own statutory requirements, many states allow operating agreements to supplant or augment its own default rules for LLC governance. At a minimum, be sure to consult applicable state law, use your best judgement and always have counsel review the LLC agreement to ensure compliance. Once the LLC agreement is signed by all parties, you can get back to focusing on what really matters—running your newly minted business.

If you have questions about LLCs or the organization process, please contact Kristin Kreuder at [email protected] or 203-803-8714. 

Kristin Kreuder is a Member of our NY-area team with over 23 years of legal and business experience in both public and private corporations and in major NYC law firms. Kristin handles a wide range of legal matters, including mergers and acquisitions; commercial transactions; technology, media, licensing and sponsorship; capital markets, venture capital and private equity transactions; and a variety of general corporate and governance matters.