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.
Division of Ownership
With multiple owners, if you do not specify a percentage ownership or other way of dividing up ownership unequally, the default rule suggests that every owner is an equal owner in the company. That means that even if Jane does one tenth of the work, if there are two members, she’d be entitled to one half of the company. Even if you intended equal ownership, a member could make a reasonable argument that there was an oral agreement to provide him with more than an equal share. For these reasons, it’s very important to ensure that you have an operating agreement that specifies how much ownership interest each member receives.
Division of Profits/Losses
The default rule for limited liability companies is that profits and losses are divided in proportion to the amount of ownership interest a person has in the LLC. There are many reasons why this doesn’t make sense for your company. For example, if one of the members of the company is a silent investor and invested in the company for 49% ownership yet only receives 10% of the distributions, this needs to be specified in your operating agreement. It is in this portion you would also specify if and when members can receive salary for their labor contributions. Salary can, of course, be decided by management later on, but it’s a far safer idea to make the decision in the operating agreement so that no one feels cheated by a later decision.
Management
This is one of the most important provisions for third persons. Banks especially want to see who has the authority to open bank accounts, sign contracts and make decisions on behalf of the company. In your case, most often, you’ll have one manager who has all the authority to bind the company. This manager can then delegate responsibilities to those below him. Imagine the manager being king of the company. He has all of the authority, but will likely need to hire others to run certain aspects of the kingdom. Using contract law, these lower level managers can make their position fairly secure, but initially, the king has the authority to change their powers in any way, including firing them.
The more complicated way to do management is to separate different areas of authority in the operating agreement itself. For example, you can have an operations manager, marketing manager and executive manager, each with her own powers and limitations. The part that makes this more complicated is that you must be sufficiently detailed enough that there’s no gaps in authority (things the company needs done that no manager has the authority to do), and limited number of overlaps (things that multiple managers would be able to make the decision on). Either failing to cover all management aspects or having overlap between managers can create large issues within the company, and this needs to be carefully construed to avoid those.
What to do in Case of Disagreements
Owners in a company disagree. It happens to every company, no matter how close the owners are. The important thing is to ensure that when the disagreements come up, there are clear rules in your operating agreement as to how to deal with them. These rules can vary wildly from a coin flip to a forced sale of the company, but the most important thing is that the way the disagreement is settled is fair. To be fair, it must be clear and it must be established prior to any disagreement or ill will. If the policy is unfair or created after disagreements start, it will give the appearance of one of the members trying to cheat the others, and therefore, can actually lead to larger problems than just the disagreement.
The key is to create policies that settle disputes when the waters are calm. Once the waters are choppy, the disagreement provisions are important, but agreeing on them without a mediator will be difficult and can lead to larger problems.
How to Change the Operating Agreement
Even though the goal is to create an operating agreement that fits every situation in the company every time, that’s simply not possible. Therefore, you need to have a clear mechanism for how the operating agreement may be changed. A two thirds majority vote of all members is a fairly common way to do it; however, you may want to look closely at who, if anybody, would be harmed with this approach. Try to find a mechanism that is fair and balanced for majority and minority members.
Sometimes, it’s a good idea to require not only a percentage vote, but also a certain number of members. If one member owns 75% of the company, under the straight percentages approach, he could change the operating agreement unilaterally. Therefore, requiring either 76% of the vote or 66% of the vote plus requiring at least two people to agree would be a good way to ensure that he has the most say, but cannot make any changes on his own.
Even with this provision clearly spelling out how the operating agreement may be changed, courts have held that there are limits to what may be changed. If you think about it, this makes sense. It would be clearly unfair if you could just amend the operating agreement to specify that Joel’s membership interest is now worth $0 and that the company has the authority to buy him out at any time at that price. If Joel was a minority member who couldn’t materially impact the vote to change the operating agreement, he could be removed through this process and therefore, the courts step in to protect him.
For more information on Operating Agreements, contact us by emailing richard@lawplusplus.com or by calling (919)912-9640.