There are countless considerations that must go into designing the perfect operating agreement for your business, but there are a few that stand above the rest in importance.
Operating Agreements are the governing documents for Limited Liability Companies. They are where you would specify the rights and responsibilities of the members of the company and how you want the company to be run. This is one of the most important documents you will have for your LLC, and a crucial one when there is more than one owner. As Operating Agreements tend to be less useful in single member LLCs, this article will focus on the most important considerations for a typical multiple member LLC.
Keep in mind that companies vary wildly in their operation, so the terms that are important to you might not be the same terms that are important to others. You want to be very thorough with this document and be sure that it covers everything that you need it to and says none of the things you do not want it to. Mishaps in this document can cause costly problems if not able to be resolved peacefully.
How to add members?
Especially if you already have multiple members, outlining how new members can be added is a very important part of your operating agreement. By default, every time you add a new member to the LLC, you dilute the ownership interest that every other member has in the company. Without specific rules as to how members are added, you could harm minority members in the company without their prior knowledge.
For example, you can admit new members with 2/3rd majority vote, as long as all the members agreed to this prior to joining the company. There are legal rights of minority members to protect them from getting abused by majority members in a company. Without these protective rules, a majority member could just keep issuing himself new ownership in the company, or give ownership to family and friends who do not have the same ideals as the minority member.
How to remove a member
Especially when there’s a clear majority member, there may be a necessity to create ways in which the company or the majority member may remove other members from owning the company. Sometimes, these provisions are called “forced buy out provisions,” but by any name, they’re provisions that allow one member or the company as a whole to buy back or force a member to surrender all of the ownership interest that a member has in the company.
Like many of the other areas of the operating agreement, you must be careful to not create an unenforceable forced buy out provision. Courts are hesitant to agree with a company that makes a wholly one sided buy out clause, especially if the courts can find that they were unclear or that the exiting member was not fully aware of what this provision meant.
Additionally, you need to be careful with these provisions, as they’re a huge source of conflict. If you’re forcing someone to leave the company, there’s a high chance this person will sue. These lawsuits can be incredibly expensive because it’s a fairly technical and very valuable conflict. The valuation in the forced buyout may vary millions of dollars from what the exiting member may believe is fair.
There are many legitimate reasons you’ll need to have a provision that allows the removal of a member. For example, if a member is required to contribute 40 hours per week to the company and does not, there needs to be available recourse to protect the company and the other members.
How can a member leave?
For a multitude of reasons, people wind up leaving the companies they’re a part of. It’s important to have a plan in place for when she does. Your operating agreement should place conditions on when a member may leave, what rights and responsibilities a departing member has and what the company must do in that event.
Under the default rules in North Carolina, a member may leave whenever she wants and can either keep or disown the ownership in the LLC. She may also sell or transfer her ownership to any person or company at any time and may delegate any of her rights and responsibilities to any person who is otherwise lawfully able to take on those rights and responsibilities.
If you don’t like those default rules, your operating agreement must change them, but this is an area where you will need to be very specific. For example, if you have a provision that disallows a departing member from collecting equity distributions without putting in a labor requirement, that departing member may want to fight the provision in court in order to maintain those ongoing payments. Any time a person is required to give up something of value, you will be facing a potential lawsuit. The more specific the rules for members leaving are, the easier it will be for a court to rule in your favor, and the less likely a person will sue to get around the rules you’ve established.
In many circumstances, the rules established in the operating agreement for how members leave are incredibly strict or one sided. Fortunately or unfortunately, depending on your position, there are additional rules set up by the statutes and by the courts that protect the rights of departing members. The easiest way to ensure you’re not treading on these areas is to make sure that what you’re requiring members to do is fair. If the roles were reversed, would you feel harmed? If you’re doing anything overly complicated, you should seek out the assistance of an attorney.
Requirements of Membership
In your operating agreement, you can specify requirements for your members. For example, you can require that members contribute labor, money, intellectual property or other forms of property. You can also require certain things such as a non-compete, non-disclosure and morality requirements for your members. The requirements may also be different for different classification of members or different for specific members. To illustrate this, you are able to require that Aaron contributes 30 hours of work every week and sign a non-disclosure agreement, whereas Tammy has to contribute her patents and not compete against the company.
Your requirements can be very expansive as long as they’re agreed to by the members. Obviously, you cannot change the requirements after the fact unless agreed to by the member who is being affected. Your requirements also cannot be against public policy. You cannot require a member to commit a crime, perpetrate a fraud, or anything similar. If you do, that member may ignore those requirements and depending on the remainder of the agreement, she may still be entitled to the membership interest.
Distributions and how to make them
Everybody wants to know how they’re going to get paid, and when they expect one level of payment yet receive another, they could wind up becoming upset, disappointed or otherwise in the mood to get back at the company, or you, for letting them down.
This section needs to be a combination of managing expectations and clearly stating exactly how payment works. If payment is based on percentage ownership, be sure to include, somewhere in the operating agreement, what labor or contribution requirements each member has. LLCs are very flexible and can divide profits and losses differently than from how ownership is divided. You can grant salaries, hourly wages, bonuses, pro rated and even non-pro rated distributions, or any combination of these.
For example, you can give James a salary of $40,000 plus he receives 15% of any distribution made to the owners even though he owns 5% of the company. LLCs can do this. Corporations are a little different and since LLCs can be taxed as an S Corporation, you should be careful with distributions in unequal percentages from the ownership percentages if you’re considering being taxed as an S Corp.
Transfers of Membership interest
Membership interest is personal property. By default, it can be bought, sold, traded, gifted, etc in any manner that a piece of furniture would be able to. You can even use your membership interest as collateral for a loan, or have a lien attached to it as a result of a judgment. The unique aspect of LLC ownership in North Carolina is that only the economic interest may be taken from you by creditors. They receive a “charging order” where they receive any income that passes down from the company to your interest, but you maintain the management and ownership interest.
For voluntary transfers, like when you sell or gift it, you’re entitled to transfer the whole membership interest or any part of it, but the operating agreement can change that. You can set up reasonable restrictions on the transfer of membership interest.
Right of First Refusal: The right of first refusal is a right granted to other members or the company to be the first to purchase the membership interest, at the same terms, if one member chooses to sell or otherwise transfer the interest away. What this means is that if James tries to sell his membership interest to Sara for $10,000, either the company or other members may step in and purchase the membership interest for $10,000 from James. Determining who is granted this right of first refusal is subject to the terms of the operating agreement, but it can be very useful if structured properly.
Courts are, many times, reluctant to uphold a provision that is an absolute restriction on the transfer of membership interest unless there’s a legitimate business interest in doing so. For example, an absolute restriction on transferring units during a period of sales negotiation might be enforceable because it keeps the value of the company higher. A restriction that prevents a member from transferring his or her shares indefinitely without reason would almost certainly be held unenforceable because it would be what’s referred to as an “unreasonable restraint on alienation” of the membership interest.
Restrictions on the sale or transfer is a balancing act between your desire to protect your business from outsiders and the unreasonable restraint on the alienation of the membership interest.
Membership interest can also be transferred involuntarily through death (discussed below), bankruptcy, dissolution in the case of a business owner, receivership and other areas where a someone is appointed to handle all, or most, of your property on your behalf. These are areas where you have to specifically address what happens. If you have the company buy the membership interest back at a reasonable price, the creditors or heirs on the other side will likely prefer this option, as they will no longer be tasked with trying to sell the property on their own.
What happens when a member dies?
Unfortunately, people die and many times you cannot predict when it happens. As much of the operating agreement’s role is to eliminate unpredictability, you need to address what happens if a member dies. You should not only address what happens with her membership units, but also what happens to her rights and responsibilities under the operating agreement. For example, if she was required to contribute 40 hours of labor every week to the company, how will this value be replaced?
If a late member offered something of great value to the company, it may be a good idea to have life insurance on that member. That way, you can either replace her or be able to survive the period of transition without her.
Also bear in mind that a member’s past contributions are still very valuable, so you cannot simply reclaim every bit of membership interest that member had upon her demise. In fact, reclaiming is not an easy thing to do. Basically, you’re telling the court that because your member died, she should be punished. That’s a tough sell!
Instead, if your member’s value is spread over time, maybe give her membership interest spread over time too. You can vest the interest over many years if need be and therefore, if she were to pass away suddenly, the remaining time period would not have passed and she wouldn’t receive all of her membership interest.
For more information on Operating Agreements, contact us by emailing firstname.lastname@example.org or by calling (919)912-9640.