One of the most important documents that should be generated when forming a new business as an LLC (“limited liability company”) is the operating agreement. Unfortunately it may also be the longest document, chock-full of boilerplate provisions. That raises the risk that people handling the process of new business formation may not give the operating agreement as much care and attention as they do other, simpler, documents.
Problems with operating agreements tend to arise in the future, sometimes years after the business was originally formed. Problems or disputes about operating agreements tend to surface when a business is either winding up or growing and changing form. Another event that triggers the operating agreement is the death or incapacity of a key member of the business.
A good analogy for operating agreements is an insurance policy. Business partners typically won’t need to look at them when all is going well, so they may not read them carefully when forming a new business. Only when something unexpected happens in governing the LLC do the partners turn to the operating agreement, and what the agreement says often guides resolution of the situation.
One of the big advantages to LLCs over corporations as an entity to do business is the flexibility of the form. The operating agreement for an LLC can be crafted specifically to the needs of this unique new business. But the advantage of flexibility an LLC brings also has a drawback: lack of predictability and increased complexity.
While the standard operating structure of a corporation is well-known – and often too formal — an LLC’s operating agreement offers an infinite number of options for how the organization may be operated. This flexibility raises the risk that inexperienced attorneys, or businesspeople, when forming a new business, may use an operating agreement form which was not intended or designed to work for the type of new business in question.
Key provisions of an LLC operating agreement, each of which involve decisions among many options, include :
- Membership interests and rights – how will profit and loss be allocated and distributed, what rights do members have to vote on issues and manage the entity, and can membership interests be transferred?
- Term, termination and dissolution – how long will the businesses continue and what happens when the business is closed or wound up?
- Capital provisions – how will the entity be taxed, financed, and how and when are distributions made?
- Management – how will the entity be managed, how will the manager be appointed and compensated, what acts require consent of members?
Choices among these many options available will have tax consequences, will determine who makes decisions, will grant controls of assets, and guide what happens at termination of the business.
If you are starting up a business, and have questions about the operating agreements, please contact David Closson, attorney and head of our Business Law Group, at [email protected].