LLC Operating Agreements – The 12 Essential Items

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“Give me six hours to chop down a tree,
and I’ll spend the first four sharpening the axe.”
– Abraham Lincoln

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A. Intro: In my work with clients regarding a wide variety of work-related agreements, I have many times seen the wisdom in this Abe Lincoln quote. Over the years I’ve learned how truly essential it is not to enter into a negotiation with a “dull axe,” that is, an incomplete grasp of what needs to be fully understood, that is,

    – Fully understanding the meaning and effect of each and every clause. Failing to fully understand every clause is like failing to strike the tree with the axe, and striking, instead, your leg.
    – Never moving forward without being certain you understand the client’s primary goal. Doing so is like doing a great job chopping down a tree . . . just the wrong one.
    – And, too, forgetting to remove the tree’s primary roots when you chop down the rest of the tree, which may make it impossible to build a new structure on the same spot – possibly, the very reason the tree was chopped down in the first place.

Once agreements, especially workplace agreements, are signed, they reside at or near the heart of the workplace relation. Sooner or later, addressing the negotiation of contract issues with a “dull axe” will likely become apparent and problematic. In this context, “Better never than late.”

B. The Four Basic Business Forms: There are four basic forms of business organization, each with its own corresponding “operating agreements,” each with its own advantages and disadvantages depending on the circumstances and challenges faced:

1. Sole Proprietorship, in which one person owns and operates an unincorporated business by themselves, as its Owner. The sole proprietor form faces the potential for personal liability for debts and claims, and so requires the use of insurance coverages for protection from a variety of risks.

2. Partnership, in which two or more persons work together to own and operate a business and share in its profits, each as a Partner. Like the Sole Proprietorship form, it needs to be shielded from business risk by either insurance coverages or other means, including its possible variant, the “Limited Liability Partnership,” or “LLP.”

3. Corporation, a legal entity, separate and distinct from its owners, authorized to act in the same ways as is a natural person-owner, each called a Shareholder. Corporate form establish a wall from “risk” by its nature, provided that it be used carefully, so as ensure the risk protection of “the corporate veil.”

4. Limited Liability Company (“LLC”), similar to a partnership in several ways, but a business form chosen largely to prevent its owners, each a Member, from being liable for the company’s financial liabilities, losses and debts.

And the many variants of Each: And, too, there are variants of each of the above, including among them the Limited Liability Partnership (“LLP”), the Not-for-Profit Corporation (“NFP-C”) and, too, the Professional Corporation (“PC”).

For a variety of reasons, including legal issues, tax advantage, adaptability, transferability, and licensing concerns, in recent years the choice of LLC’s has become increasingly seen as preferable with investors, professionals, private equity participants, and among the financial community.

This blog post is not intended to be a treatise on the many and varied “do’s and don’ts” of each of those forms of doing business, and each of their operating agreements, but instead only to present in summary fashion the 12 Essentials of one of them, namely, the Limited Liability Company Operating Agreement.

C. The 12 Essentials of an LLC Operating Agreement: Simply put, if you are preparing or reviewing a draft of a proposed LLC Operating Agreement, or are discussing a proposed amendment, look for these twelve “Essentials,” and focus upon how they may best serve your interests. If any does not appear in the agreement before you, there may well be a problem. Of course, you should seek the assistance of an experienced professional because, as Einstein said, “It’s important to know things, but far more important to understand them.”

1.  The “Simple Basics”: These are the most basic of the “basics” of our “LLC Operating Agreement Checklist,” not to be overlooked: (i) Company name, (ii) Company purpose, (iii) registered office, (iv) principal place of business, (v) choice of applicable law, and (vi) method of dispute resolution.

2. Members and Member Classes: Typically, we look to see (i) the LLC Members’ identities, (ii) whether there are any different classes of Members, (iii) how Members are each categorized by different “classes,” among them: (a) Active, (b) Retired, (c) Managing, (d) Founding, (e) Officers, and (f) Passive. Generally, each “class” will have its own tailored rights, duties, interests, voice and profit shares.

A Member’s class categorization may be based upon a variety of factors including (i) their investment level, (ii) whether they provide services to the LLC, (iii) how and when she, he or it became a Member, (iv) how she, he or it is allowed to, or perhaps required to, leave their membership behind, and (v) the consequences of their doing so.

Note that in an LLC, “Member” means essentially the same as partner, shareholder or unit owner, found in other forms of entity ownership.

3. Each Member’s “Ownership Interests”: It is very important that an LLC Operating Agreement sets forth either (a) the amount, type and/or percentage of each Members’ interests in the Company, or (b) a formula by which they can be easily and definitively ascertained. Generally, Membership Interests may be purchased, earned, accrued, forfeited, transferred to others, with or without a vote of other Members, or upon death, disability, forfeiture or resignation, as examples. And, too, the date of each Member’s entry into LLC Membership, is not to be overlooked.

4. Each Member’s Respective Entitlement to Profit Distributions: As LLC Members may have different ownership interests, in the same ways and dependent on the same or similar factors, so too might Members have differing rights to distribution of varying degrees of company profits, and, too, from different streams of those company profits. Here, too, precision and clarity about numbers and/or formulas with which to reach precise Members’ profit distribution rights, are wise, encouraged, if not essential.

5. Each Member’s Rights to Request Audit of Company Books and Records: To keep all within the bounds of propriety, and discourage mistrust and jealousies from arising, there is nothing better than giving all Members of an LLC, both (a) a process to request and (b) a right to receive, an audit of financial affairs. There is nothing like accountability to keep people acting “on the right side of the right line.”

6. Management Structure, Authority, and Limits on Authority: There are three basic ways to structure the management of a Company: (a) by the Company’s Owner-Members, themselves, with each significant decision requiring an agreed percentage vote; (b) by one or more Owner-Members being elected by their fellow Members by vote, and (c) by the services of a hired Professional Manager.

In each instance, the authorities granted to the Manager(s) ought to be set down in the LLC Operating Agreement, and limits on the exercise of those authorities, as well. Identification of one Member or hired Manager with relevant expertise to watch over and be responsible for Tax Matters, is a sure sign of wise management.

In larger, more complex businesses, Managers may hire skill-specific Officers, as examples, Chief Information Officer, Chief Human Capital Officer, and Chief Logistics Officer.

7. Decision-Making and Governance: Every company is unique, and so its decision-making will be, as well. It is to be expected that some decisions will require the votes of Members, and some will not. There is wide latitude in this respect. As examples, (i) one particular employee or Manager could be permitted to make decisions entailing expenses of up to $5,000 (what some might call a “Day-to-Day” decision), (ii) another decision may require a majority of Members’ votes, perhaps the hiring of a new employee with base salary of $100,000 or more (what some might call a “Significant Decision”), while a decision to close down the business or modify the LLC Operating Agreement (what some might call a “Major Decision”) may require a unanimous vote of Members.

How votes are allocated may be particular in a unique way. For example, it is not uncommon for Members holding a significant portion of total Company interests to be given votes proportional to their holdings. However votes are distributed, allocated or counted, and decisions are to be made, it is certainly wise to make certain that all Members’ votes are allocated and counted in a fair and transparent manner. 

8. Members’ Fiduciary Status and Non-Competition Restrictions: In some states, but not all, LLC Members are deemed by law to act as “fiduciaries” of the Company and its Members. “Fiduciary” means one who must act in the highest standard of trust. It is not common, but we sometimes do see provisions in an LLC Operating Agreement that stipulate that Members do not have to act in a fiduciary capacity. In our view, that is a matter of real concern, as the absence of such accountability may raise a degree of suspicion, and they are thus wise to be removed, or at least limited to certain, specified circumstances.

With increasing frequency, we find in LLC Operating Agreements clauses containing “non-competition” provisions, which prohibit a Member from acting in competition or conflict with the Company or its interests (a) during the term of the Member relation, for (b) a period after being a Member, or (c) both.

9. Indemnity: As in all organizations of any type, sometimes people make mistakes. And sometimes, those mistakes grow into conflicts, claims and even lawsuits. Every operating agreement of any kind of organization should provide that the company will protect its members, partners or shareholders who act in good faith, should a claim arise or a lawsuit commence. The primary ways this is commonly achieved is by (a) maintaining an insurance policy that covers Members from personal loss, cost, expense, or liability, or (b) using the company’s own financial resources to do so, or (c) both. All Members, their families and their assets should be personally protected in this fashion.

Might a Member herself or himself, as the case may be, be required to indemnify the company and its Members? Typically, yes, but only if he or she has brought about the underlying problem due to behavior that is found to be improper, illegal, in violation of Company policies, or, indeed, criminal or fraudulent. 

10. Amendment of the LLC Operating Agreement: There is nothing wrong, and everything right, with an LLC Operating Agreement evolving over time, as needs dictate, adapting to new events and circumstances. Needed in all such instances, is a clear and transparent – and thus trustworthy – process of doing so.

11. Departure and Removal of Members: “The most important part of any relationship is ending it well.” Perhaps second-in-importance to come upon in an LLC Operating Agreement are what steps and measures exist in the Agreement to (a) safeguard the departing Member’s rights, interests, assets and reputation in the process of departure, and (b) the same with regard to a Member’s involuntary removal only for specified, detailed, and identified reasons, with an opportunity to explain or prove false any allegations of impropriety, prior to formal removal.

12. Dissolution or Sale of the Company: This is surely the Number-One provision of an LLC Operating Agreement that must be identified and analyzed with care during review. The Company is the very reason each of its participants has come together, and contributed capital, assets, expertise and efforts. Dissolution or sale of their opportunities, hopes, dreams and adventures on anything other than the fairest basis should be well protected.

For anyone to seek dissolution or sale of the Company without there first being clear, specified and mandatory steps taken to protect all Members is nothing less than shameful. Tax issues, in particular, are essential to have counsel on, as different monies and different assets and asset classes can be evaluated and allocated differently, and characterized wrongfully unless independent, experienced and objective tax advice is part of the process. 

D. Conclusion: Whether you are forming, joining, investing in, purchasing, selling, departing from, or dissolving an LLC, your first step is to review and consider these “12 LLC Operating Agreement Essentials,” and not once, but twice or three times. It couldn’t hurt and can only help. And, too, it is only wise to seek experienced counsel to help identify, assess and eliminate any risks that might endanger your assets, that only a trained eye can be expected to see.

And bear in mind, as well, the truism that “If things are going well, no one reads the Operating Agreement.” It’s only when issues seem unresolvable, dissension rules the day, people are angry, and there’s whispers about “lawyers,” that the Operating Agreement is turned to for “guidance.”

This entire process is intended and designed to give you, as a prospective or actual Member, the “strong hand” of a prepared person, and the contented smile of a person who has done her or his “homework.” That is something only a true “sharpened axe” can give you.

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In Summary . . .

Becoming a valued and respected participant in a Limited Liability Company – as Founder, Manager, Officer, Investor or Member – is a step not to be taken lightly, but only with care, consideration and caution. Just like chopping down a tree. To minimize risk and maximize reward, every LLC should have a written operating agreement to (a) discourage the likelihood of poor judgment, (b) avoid the consequences of bad behaviors, and (c) avoid missed opportunities.

In working with clients to analyze Limited Liability Company (“LLC”) Operating Agreements we have identified these “12 Essentials” to be considered before you “sign on the dotted line.” They are not guarantees of safety and success, but their identification, careful review and skillful incorporation together comprise a basis for confidence in your endeavor.

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