Last week I started telling you how to setup a new limited liability company. I went over some LLC basics, deciding where to file, choosing a name, and putting together your Articles of Organization.
Over the next two weeks I’m going to walk you through the operating agreement—the most central document in any LLC. This week we’ll look at operating agreement basics and control issues. Next week we’ll look at economic issues and taxes.
I have to remind you, before we get started, that this is not legal advice. Every situation is somewhat different. You should talk to a lawyer before you get started on your operating agreement.
What is an Operating Agreement?
Corporations have their bylaws. Your tree fort had a secret handshake. LLCs have an operating agreement. It’s the cornerstone of your endeavor. It gets all the stakeholders on the same page.
The operating agreement is where you put all of the important rules about how your LLC is run: who puts dollars in, who gets a vote, who gets dollars out, who pays taxes, and what happens if you hit an iceberg and the whole thing sinks to the bottom.
If you are starting up a single-member LLC—meaning that the LLC will only have one owner—then your operating agreement can be swapped out for a short document called a “written declaration.” (Don’t worry, there is no special box to check or form to file if you are starting a single-member LLC. In most states there is just one version of the Articles of Organization, and it doesn’t ask about ownership.)
A written declaration doesn’t need to cover much ground. As the sole owner, you’re making all the rules. But a few things are important. First, your written declaration should state the name of the company, its address, and that sort of thing. Second, it should clearly give you, as the owner, authority over the business. Third, I personally think it should give you authority to sign under a few different titles: president, secretary, and treasurer being the most important. This may be useful when signing bank documents. But you can always sign as “member” or “sole-member” to keep it simple.
Finally, make sure that the written declaration states clearly that no membership interests in the LLC may be issued unless they are subject to the written declaration. Then couple that with a provision stating that if the LLC ever has two or more members, the members must adopt an operating agreement. This will help to prevent the company from ending up in a situation where there are multiple owners without adequate rules to govern them.
What Does an Operating Agreement Need?
You will need an operating agreement if you’re forming a multi-member LLC. Any LLC with more than one owner, even if some are just silent investors, is a multi-member LLC. Your operating agreement can include as much information as you want it to include, or as little. But just like any other agreement, whatever you leave out will be open for interpretation and dispute. It’s good business practice to make sure that your company has a clear and comprehensive set of rules.
A good operating agreement will typically run somewhere in the range of 30 to 90 pages. Some are more comprehensive than others, and may include buy-sell provisions, rights of first refusal, vesting, and complex tax provisions. Regardless of the nature of your enterprise, no operating agreement is complete until you have at least thought about the following issues.
Ownership interests in an LLC are typically called units. Sometimes they are called shares. Sometimes ownership is simply indicated by percentage. But whatever your preferred nomenclature, your operating agreement must cover ownership interests in detail. There is very little that is standard when it comes to LLC ownership. You cannot simply rely on the LLC statute.
In general, an LLC does not tell the state how many units it has authorized or issued. It is left to the operating agreement to sort this out. And there is no official document stating what rights each owner has. (Unless and until a securities registration is filed.)
Make sure your operating agreement states clearly who owns what—though it’s easier to put the actual names and numbers in an appendix that’s easy to update. Make sure you know what contributions were made in exchange for ownership—this should be in an appendix too. And definitely make sure that you know what control rights and economic rights accompany your ownership. Will owners get one vote per unit, or one vote per person? How often will they vote? Will owners be required to contribute more capital if the business begins to fail? Do they have the right to withdraw, or demand distributions? Will there even be distributions? Some of this will be covered in next week’s post on operating-agreement economics.
Management structure goes hand-in-hand with ownership structure. LLCs are, by default, controlled by their owners. That arrangement is called a “member-managed” LLC. But LLCs may also create managers to oversee the operation, much like directors oversee the operations of a corporation. That’s called a “manager-managed” LLC. Not very creative, but there is a big difference.
In the typical manager-managed LLC, owners take a back seat. They have no say in the day-to-day operations of the company. Owners still get to vote on major, course-changing actions, like whether the company is acquired, or takes on massive debt. And the owners may vote on who is a manager. But unless the operating agreement explicitly leaves some control rights to the owners, it’s the managers who call the shots.
There are benefits and drawbacks to the manager-managed structure. Venture-capital and hedge funds are typically manager-managed LLCs, with the investment firm taking the manager role and the investors acting as passive owners. But that structure can be a disaster if you intend your business to be closely held and managed accordingly.
Be careful with the decision of whether or not to have managers. And be careful with how much authority you give them.
So far we have covered the basics of what an operating agreement is, when you need it—and when you can get by with a written declaration—and what to think about when it comes to ownership and control issues. Next week I’ll talk about the economic aspects of an operating agreement. When things fall apart, control is really important. But when things are going well, it’s the economics everyone cares about. That’s the fun part. But it’s also where the complex tax issues come into play. Stick around. You’re going to love it!