A business that operates as a limited liability company for legal purposes will have an "Operating Agreement" to govern the legal relationship between the company and its various members. The structure of the operating agreement will vary depending on the company's business and its long-term goals. For example, the operating agreement for a technology company may vary significantly from that of a real estate venture. The following is a brief discussion of recommended provisions for consideration in an operating agreement.
Legal Formalities An operating agreement should address certain legal formalities. For example, it should clarify the company's registered office and registered agent for legal correspondence.
Capital Accounts and Member Capital Contributions An operating agreement should provide a structure whereby a company keeps capital accounts to track contributions and distributions of cash and property by or to each member and each member's share of company profits and losses. The company's capital account structure should be designed to comply with applicable tax requirements.
Allocations of Company Profits and Losses An operating agreement should describe how the company's profits and losses will be allocated for economic and tax purposes. Allocations of profits and losses is a "flow-through" concept that should be distinguished from cash distributions. For example, a profitable company may reinvest its cash profits back into the business during a given year, but the company's profits would still be allocated among its members for the purposes of adjusting the members' capital account balances and for tax reporting purposes.
Pre-Liquidation Cash Distributions The process for determining the timing and amount of cash distributions among the members should be described, including distributions to allow members to pay tax liabilities related to their share of any flow-through profits for the year. If the company has a preferred class of units, the cash distribution provisions should address cash-flow preferences among the members.
Liquidating Distributions The order for making liquidating distributions and liquidating the company should be described in an operating agreement. As in the case of pre-liquidation distributions, any preferences among members should be accounted for in the liquidation distribution provisions.
Managers' Powers and Limitations A limited liability company's power to act is vested in its manager or managers. An LLC may have a single manager, two managers or a board of managers. The operating agreement should govern how the manager or managers will make their decisions and whether some decisions will be subject to approval by the company's members.
Members' Voting Rights An LLC may have both voting and nonvoting units outstanding. The operating agreement should set forth which units have voting rights and the process by which voting will occur. In some cases members may also be subject to noncompetition, confidentiality or other agreements to protect the company's business.
Transfer Provisions An operating agreement should describe any special provisions that relate to transfer of the company's units. For example, will the company or its members have an optional or mandatory purchase obligation in the event of the death, disability, divorce or bankruptcy of a member? Will the company and its members have a right of first refusal or right of first offer in the event that a member wishes to sell his, her or its units to a third party? Will a sale of units to competitors of the company be precluded? Can transfers be made to relatives or trusts of a member for estate planning purposes? What would the payment terms be for a company purchase of units? Can a majority of members force a minority to sell their units if a complete sale of the company is negotiated with a buyer? Can a minority unit holder force a buyer to purchase its units in the event of a proposed sale of a majority of the company's units?
Other Provisions Examples of other provisions that an operating agreement may provide include preemptive rights in the event of the issuance of new units, anti-dilution protection provisions, indemnification rights, and the issuance and vesting of profits interests issued to employees.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
