In a previous discussion about LLCs, we emphasized the pivotal role that an operating agreement plays in shaping the internal governance of Limited Liability Companies. Often overlooked or hastily drafted, the operating agreement stands as the keystone document that outlines the rules and regulations governing an LLC. In the realm of multi-member LLCs, it is not merely a recommendation but a vital necessity to have a well-structured, written operating agreement in place.
The core elements encapsulated within an LLC operating agreement are multifaceted, encompassing a comprehensive array of provisions that dictate the LLC’s operational framework. These provisions span various facets of the business, ranging from equity structure, management, voting, limitation of liability, and indemnification, to records, anti-dilution protections, transfer restrictions, buyout mechanisms, confidentiality and restrictive covenants, and general provisions like governing law and dispute resolution. Let’s delve into each of these components in detail.
Membership Interest: The bedrock of an LLC’s equity structure is the membership interest, often expressed as a percentage. This percentage interest can evolve with the addition of new members to the LLC. It’s crucial to understand that a membership interest comprises two vital components: an economic interest and a management interest. Some LLCs even opt for a unit-based approach, providing their equity with a stock-like appearance, with units sometimes colloquially referred to as “shares.”
Classes of Membership Interests: LLCs enjoy unparalleled flexibility in structuring their capital. They can create various classes of membership interests, such as non-voting interests, common interests, preferred interests, convertible interests, and profits interests, among others, tailored to meet their specific needs.
Contributions and Capital Accounts: Each member maintains a capital account, with initial percentage interests determined based on the value attributed to their initial capital contributions. Contributions can take the form of cash, property, services, promissory notes, or other obligations. The operating agreement should outline whether ongoing contributions or future capital calls are expected.
Allocation of Profits, Losses, and Distributions: While the default rule typically involves proportionate allocation of profits, losses, and distributions among members, the operating agreement has the power to deviate from this norm. It can establish unique economic rights for each class of units and modify allocation rules between members of the same class, enabling, for instance, a member with a 50% interest to receive 100% of profits or losses in a given year.
An LLC’s management structure can be member-managed or manager-managed. In the case of a manager-managed LLC, the operating agreement details the appointment of managers, their roles, meeting frequency, voting procedures, responsibilities, terms, and procedures for manager removal and replacement.
While the standard rule dictates voting in proportion to percentage interests, the operating agreement can introduce deviations. It may withhold voting rights entirely for specific members or classes, base voting rights on capital contributions, capital commitments, or capital accounts, or even grant veto rights or supermajority votes for certain members or managers.
Limitation on Liability, Indemnification
This section addresses the fiduciary duties of managers. Legal developments in this domain necessitate a dedicated discussion in a separate blog post.
Books and Records
This self-explanatory section governs record-keeping and member rights to inspect corporate and accounting records of the company.
Anti-dilution provisions allow a member to maintain their membership interest percentage when the LLC issues membership interests to new members. These protections may include veto rights on new issuances, limitations on capital calls, and pre-emptive rights to purchase new membership interests.
Restrictions on Transfer
This section covers the assignability of membership interests. Often, a membership interest can be assigned, but management rights necessitate compliance with restrictions on transfer and, if specified in the operating agreement, approval from managers.
Certain events, such as death, disability, bankruptcy, or employment termination, may trigger a buyout option for the company or other members. The operating agreement should outline the buyout procedure, pricing, and payout terms, which can be structured creatively.
Tag Along and Drag Along Rights
Tag along rights protect minority members during the sale of a majority member’s interest, while drag along rights facilitate the sale of the entire company’s equity.
Confidentiality and Restrictive Covenants
This segment incorporates provisions like non-compete and non-solicit clauses, safeguarding the company’s interests.
Liquidation and Dissolution
Here, the operating agreement specifies the events or conditions leading to the dissolution of the LLC. It outlines the winding-up procedures and the distribution of assets upon dissolution.
The concluding section includes clauses related to dispute resolution, amendments to the operating agreement, and provisions affecting members’ limited liability and economic interests.
As apparent, an LLC operating agreement is a comprehensive document, often spanning over 30 pages, reflecting the intricate nature of LLC governance. Moreover, it is a living document that should adapt to the evolving needs of the LLC. A well-crafted operating agreement is an indispensable tool for addressing a multitude of scenarios and challenges, serving as the linchpin for a successful Limited Liability Company.
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