Every LLC should have an Operating Agreement. Without one, you’ll be governed by your state’s “default” rules and you may not like those.
An Operating Agreement is the governing document for an LLC – it establishes the rules under which the LLC will operate and will cover a lot of ground including voting rights, economic rights, and more. Some are just a few pages long but more often they are 15-20 pages or more.
If you don’t have an Operating Agreement, then your LLC will be governed by your state’s “default” LLC rules. Those are created by your state’s legislature and they are not desirable in many situations.
To help you better understand what should be included in your Operating Agreement, we’ve prepared this list of 12 critical elements you should consider. Also note that, while this seems like a lot to consider, your startup or small business lawyer should be able to walk you through common solutions to these issues.
The 12 Elements You Should Consider:
- Membership. Obviously you should consider who is, and who is not, a member of your LLC (owners of a LLC are called members). This is usually listed in your cap table, an attachment to your Operating Agreement.
- Adding/Removing Members. You need to decide how new members may be admitted, whether members can withdrawal, whether members can be expelled, and what happens if a member dies or becomes incapacitated.
- Contributions. You need to determine, and document, the contribution each member is making in exchange for receiving an ownership interest. This can be in the form of cash, property, services, or a combination of those.
- Equity Split. You must also determine how much equity each Member will receive. Consider things like how much they are contributing and what their responsibilities will be. And also consider overall fairness. Most businesses fail due to people problems (see Noam Wasserman for more on that). So you should always aim to be fair with your equity split to avoid arguments later.
- Prohibited and Permitted Transfers. You should consider adding rules that prohibit a member from selling or otherwise transferring their ownership interest without some level of consent from the other members. And related, you should consider adding some permitted transfers including Rights of First Refusal, Drag Along Rights, Tag Along Rights, estate planning transfers, and optional redemptions following the death of a member.
- Voting. You’ll also need to establish what voting rights each member will have and what voting thresholds you’d like to use such as majority vote, super majority vote, and unanimous consent. Different decisions might require different thresholds for approval.
- Management. If your LLC is Manager-Managed (which is common and means one or more managers mange the business rather than the company’s members), then you should consider spelling out the authority of the manager and any limitations you might place on the manager (such as prohibiting the manager from adding new members to the company and restricting the manager’s ability to sign contracts over a certain dollar amount).
- Intellectual Property. You need to include provisions that make it clear that all work product and associated intellectual property created by the members will be owned by the company and not the individual members.
- NDAs and Restrictions on Outside Business. You should probably include confidentiality obligations to prevent members from disclosing the company’s confidential information to third parties and you might also want to restrict the members from owning interests in other businesses that compete with your Company.
- Taxation. You’ll need to determine how you’ll be taxed and include provisions regarding that in your Operating Agreement. LLCs can be taxed as a disregarded entity, a partnership, an S-Corp, or as a C-Corp.
- Guaranteed Payments. If you are taxed as a partnership (which many LLCs are), you should decide if any of the members should get Guaranteed Payments (which is basically the same thing as a salary).
- Distributions. And last, you need provisions that outline how money gets distributed. You should think about making distributions mandatory to help members pay their income tax obligations and making distributions of profits optional.
We know, that’s a lot to consider. But with the right legal advice you’ll be able to draft an operating agreement that works for your unique situation.
*This article is very general in nature and does not constitute legal advice.