Corporate Law Blog

The LLC Operating Agreement - Why is it important and what should it say?

An LLC is a fairly limitless business form. Generally, an LLC can be and act in any number of ways, tailored to how you want your company to operate. The Kentucky LLC statute provides several gap-filler provisions, but most of these can be overridden by the terms of the operating agreement, making the operating agreement a nearly indispensable part of any LLC.

The operating agreement is not a requirement of the LLC statute, but it should be a necessity in terms of providing a set of rules for the running of the company. It functions as the backbone of the LLC and sets a system in motion that should run smoothly and guide the business so that the day-to-day business can be handled efficiently. An operating agreement should be crafted with the specific company it will pertain to in mind, with particular attention paid to company goals and the relationship between the members. Companies really need to work with an attorney to draft the operating agreement - careful drafting in the beginning will save a lot of stress in the end.

An operating agreement is also a good way to show a court that the owners have been conscientious in setting up the business legitimately to maintain the shield from personal liability. If drafted carefully, it can also handle internal conflicts and provide peaceful resolutions to problems that arise. Ultimately, it also allows the company to run the way the owners want it to, rather than run according to the default provisions of the LLC Act.

Operating Agreement vs. Business Plan

Generally, an operating agreement sets up the structure and operation of the business for the life of the business. That is not to say that members shouldn't review this agreement from time to time, but the operating agreement is more in the nature of a skeleton outline of the business. A business plan sets out company goals along a timeline and is more of a roadmap that gives an indication to the members and others (lenders, for example) of where the company is going and how it will theoretically get there. A business plan can be beneficial for lenders to see, for instance, when considering a business loan.

What Should the Operating Agreement Contain?

There are some provisions that every agreement should contain, just as a general rule:

Operating agreements should specify how the profits (or losses) will be split among the members and when/how distributions will be made, or whether they can be withdrawn at will (and LLC members must pay taxes on profits whether distributed or not).

The agreement should also specify how major business decisions will be made, as well as what happens to minority members or dissenters. For instance, Kentucky's LLC Act has no dissenter's rights, so the agreement drafters should consider whether to write those in. The agreement will ultimately govern the relationship between members in a majority and the minority on any given decision.

The agreement should definitely contain provisions for how to add or remove members and the circumstances that can rise to that. Will the LLC dissolve when a member leaves? Can a member be forced out? How can a member cash out, and what will the effect be on the LLC when he or she does? The operating agreement should answer all of those questions.

The agreement should create a managerial structure and a series of roles that define the decision-making, from the day-to-day operation on up to major business decisions. What sort of decisions will require a vote, and what can be left to the discretion of individual members? Who gets a vote, and how does voting take place? How is the power of the vote allotted? Is a regular majority okay, or should you require a supermajority or even unanimity for some decisions?

Also, the agreement should include provisions governing amendment of the agreement itself - how can it be amended, what sort of vote does it take, what process is necessary, and it is the same for all amendments to the agreement.

There are plenty of ways to anticipate events that ordinarily could lead to the end of the LLC. For instance, drafters can insert transfer restrictions so that members can't transfer membership or ownership without consent of the other members. The agreement can include a right of first refusal, so if a member wants to sell to a non-member, he or she first has to offer to sell the interest to the other members.

General vs. Specific Provisions

An operating agreement can be as simple or complex as the members want it to be, but leaving the provisions of the operating agreement very basic or vague can set up a series of problems for the LLC that it has to resolve. The entity then becomes a continuous exercise in problem-solving. It's best to set as many rules as possible to stave off any potential conflicts, especially while everyone is at the beginning stages of the entity and still working well with the others. Organizers will want to resolve conflicts now and solidify any verbal agreements as to how the company will run.

Planning for the end

In the beginning of the business is the best time to plan for the dissolution or winding up of the company. Just as with a marital prenuptial agreement, members should make plans for how they would like to see the company end while everyone is still cooperative and happy.

The good thing about planning ahead is that members can cut off a lot of avenues ahead of time that could lead to greater conflict and really make dissolution a real mess. An operating agreement can limit the ability of minority members to interfere with the business decisions of the majority, set up forceful removal of members who won't cooperate, and set in stone all the terms and methods of valuating members' shares so that there isn't litigation over them in the end. Any possible problem that can be accounted for ahead of time is just that much more time not spent in court fighting over it.

Sometimes the operating agreement gives more power to a member than anyone anticipated. For instance, a minority member unhappy with the outcome of a vote may threaten dissociation that requires a cash out that may cost the entity in capital to the point where the decision made is no longer feasible and might be reconsidered. It's important to understand how the power and vote is distributed throughout the operating agreement and ways in which both the majority and the minority can affect or even override each other.

For assistance with drafting a comprehensive operating agreement, contact the attorneys at McBrayer.

This article does not constitute legal advice.