An Operating Agreement is an agreement among the members of a limited liability company that defines the LLC’s management structure and governs the operation of the LLC, including the members’ contractual rights, obligations, and restrictions relating to their membership interests in the LLC. An LLC with only one member may use a simple short-form Operating Agreement because all the power to control and carry on the operations of the LLC is held by a single person; however, LLCs with multiple members often need more lengthy and complex Operating Agreements because they need to address the many additional issues created by multiple member ownership. This article summarizes the top 10 considerations in preparing LLC Operating Agreements, focusing on LLCs with multiple members.
1. Management. An LLC may be managed by its members or by one or more appointed managers. Managers of an LLC are similar to corporate officers and directors, as they are responsible for strategic decisions and the day-to-day running of the business. There are many reasons to choose manager management, for example when not all members are meant to have a vote on operational decisions, or when operational decisions are to be made by a non-member. Managers may be members of the LLC, but they are not required to be members. It is not uncommon for an LLC to be generally managed by managers, but a member vote is required to take certain actions. Whatever management structure is chosen, it is very important to clearly set forth in the Operating Agreement how decisions must be made, including when and if meetings are required, the voting percentage required to take certain actions, and whether certain authority may be delegated to others (like officers). If manager management is chosen, the Operating Agreement should also clearly set forth the procedure for appointing, removing, and replacing managers, and whether the authority of the managers will be limited in any way. It is also common for an Operating Agreement to limit the liability of managers and to provide managers with indemnity from the LLC, in each case except for certain egregious behavior.
2. Transfer Restrictions. The provisions of an Operating Agreement addressing restrictions on the transfer of membership interests are often the longest and the most difficult to negotiate. There are many common types of restrictions and many ways to draft them. Many Operating Agreements start off with a general rule that members cannot sell or otherwise transfer their membership interests unless approved in advance (typically by the manager or some percentage of the members) or allowed under another provision of the transfer section, such as a “permitted transfer” provision, a right of first refusal, or right of first offer. Such “permitted transfers” are often to closely related people, such as immediate family members, affiliates, and controlled entities (such as family trusts). A right of first refusal requires a member who has received a bona fide third-party offer for a sale of its membership interests to first offer those interests to the LLC and/or the other members before completing the sale to the third party. Similar to a right of first refusal, a right of first offer requires a member to offer its membership interests to the LLC and/or the other members before offering to sell to third parties. Drag-along rights protect the majority member(s) of the LLC, allowing it/them to require the minority members to sell their interests in the LLC if doing so aids in the sale of all or a significant portion of the LLC to a third party. Conversely, tag-along rights protect the minority members in the LLC, requiring controlling members desiring to sell all or some portion of their membership interests to allow the other members to participate in the sale and sell their interests on a pro rata basis.
3. Buy-Sell Provisions. Buy-sell provisions describe the events and procedures for when members are permitted or required to buy or sell membership interests from each other, and they allow the LLC and its members to plan for certain situations, such as a member’s bankruptcy, death, disability, divorce, or termination of employment, and for members that are entities, change of control and dissolution. These “triggering events” allow the LLC and/or the other members to elect to buy out such member’s entire membership interest. It is very important to set forth the procedure for notice of the triggering event, exercising the right to purchase, purchase price and payment, and timing of closing. A clear procedure for valuing the transferred membership interests should be agreed upon when the parties first enter into the Operating Agreement, as the parties’ interests may not be aligned after that time.
4. Deadlock. The operations of an LLC can sometimes be halted if an agreement cannot be reached by members holding sufficient authority to take certain company action. This kind of “deadlock” can be a particularly difficult issue for an LLC owned 50/50 by two partners where decisions simply require a majority vote. Operating Agreements sometimes provide for one or more methods to resolve these deadlocks, for example: (1) providing for a tie-breaking vote to be made by an agreed upon third party with experience in the LLC’s business, (2) mediation or arbitration, and (3) buy-sell provisions. One such buy-sell provision that can be useful in a deadlock situation is a “push-pull” provision, which allows either member, in the event of a deadlock, to offer to buy out the other member’s interest at a certain price. This becomes the terms and conditions under which a buyout will take place. However, the other member can either agree to the terms and sell its interests or force the offering member to sell on the same terms. This approach can help to ensure that the offering member will make a reasonable proposal, as the other member will be the one deciding which member is ultimately the buyer and which is the seller. This approach is particularly helpful when the parties would otherwise not agree on a traditional valuation mechanism. If the Operating Agreement is silent on resolving these deadlocks, the members must either resolve the matter by themselves or be forced to litigate the matter.
5. Capital Contributions. A capital contribution is the payment a member makes to the LLC in exchange for its membership interests. This payment can be made in the form of a contribution of new cash or assets or can consist of a rollover of a member’s existing equity in a target company that has been acquired by the LLC (or its subsidiary) in a buyout. The percentage of membership interests in the LLC that a member receives in exchange for its capital contribution is typically a negotiated matter between the parties. Operating Agreements also typically address whether members may be required to make additional capital contributions in the future, as well as how such additional capital contributions are called (capital calls), and the consequences of a member failing to make its share of the capital call. Defaulting members may be subject to dilution, outright buyout, loss of voting rights, lawsuit by the LLC for collection, and other consequences of varying severity.
6. Allocations and Distributions. This section of the Operating Agreement sets out how the LLC’s economic profits and losses are allocated among the members and how and when company funds are distributed to the members. The company’s tax advisors should review the allocations and distributions section, along with any other section of the Operating Agreement addressing tax matters. Although the allocations section specifies the way that the LLC allocates profits and losses for tax purposes, the distributions section describes the priority of payments to the members. For this reason, the distribution section usually is the place where the Operating Agreement reflects the members’ economic arrangement. Distributions can be based simply on a member’s percentage ownership of the LLC (generally calculated by dividing the balance of a member’s capital account by the sum of the capital accounts of all the members) or on more complicated priority-based formulas. For example, certain members may receive the value of their contributed capital, plus a preferred return, before any other members receive distributions. The provision containing these priority-based formulas is often referred to as the waterfall provision, since it sets out, from top to bottom, the order of priorities for distributions among the members.
7. Admission of New Members & Withdrawal. In some states, including Louisiana, a transferee of an LLC membership interest is only an assignee and not a full member of the LLC unless and until admitted as a member by the LLC’s members, either unanimously or by some other method set forth in the Operating Agreement (or formation document). Such an assignee essentially has only an economic interest (e.g., rights to distributions and sharing in profits and losses) with no voting rights or other right to participate in the management of the LLC. Operating Agreements sometimes make exceptions to this general rule, for example regarding spouses and immediate family members of transferring members; however, many LLCs prefer that “member” status remains subject to member approval in all cases. If the LLC allows a new member, whether by transfer of existing membership interests or by issuance of new membership interests, it is important to require new members to “join” the Operating Agreement and sometimes sign on as a personal guarantor (along with the existing members) of certain LLC debt or other obligations. The Operating Agreement should also address whether a member may withdraw from the LLC, as default state law on the issue may be undesirable. For example, under Louisiana LLC Law, unless otherwise specified in a written Operating Agreement, a member of an LLC not entered into for a term may resign or withdraw upon not less than thirty days prior written notice to the LLC and to each member and manager, and such member is entitled to receive, within a reasonable time after withdrawal or resignation, the fair market value of such member’s interest as of the date of such member’s withdrawal or resignation.
8. Preemptive Rights. Preemptive rights allow members to buy their pro rata share of future issuances of membership interests by the LLC, which is designed to protect members against dilution of their membership interests. For example, an LLC offering preemptive rights to its members entitles a member holding 10% of the LLC’s membership interests to buy 10% of that LLC’s future issuances of membership interests. Exercising this right allows the member to maintain a 10% membership percentage after the issuance.
9. Minority Member Protection. LLC laws do not traditionally provide much protection for minority members, so minority members should use whatever leverage they have to include in the Operating Agreement certain provisions protecting their interests. Without such protections, they will likely have little or no impact in votes over company decisions, and their membership interests can be subject to dilution or even buyout on less than favorable terms. One kind of protection sometimes afforded to minority owners is to require their approval for certain “high level” LLC action, for example selling the business, merging, or dissolving the LLC, incurring debt outside the ordinary course of business, issuing new membership interests, or admitting new members. Another is to allow a minority member to appoint one of the LLC’s managers, which gives that minority member a voice in manager decisions and keeps that member informed of all aspects of company action requiring manager approval, even if that manager’s vote is ultimately no greater than the minority member’s ownership percentage. Another common protection against dilution is to grant preemptive rights to all members, which allows members to purchase their pro rata portion of any new issuance of membership interests by the LLC. Finally, a minority member may be able to negotiate enhanced economic rights like distribution and liquidation preferences.
10. Tax Election. LLCs with multiple members are generally treated as partnerships, or “pass-through” entities, which are not themselves subject to US federal income tax unless they specifically elect otherwise. This allows them to avoid the entity-level tax that is imposed on corporations. An LLC can also elect to be treated as a corporation (either C corporation or S corporation) for US federal income tax purposes. An LLC taxed as a C corporation may have unlimited members (unlike an S corporation) but is subject to double taxation where income is taxed at the LLC level and also at the member level. An LLC taxed as an S corporation offers pass-through taxation, but there are limits on the number and types of members allowed. A CPA or tax attorney should be consulted to make sure the most advantageous tax election is made.