The Rise of the LLC

The limited liability company (commonly referred to as an “LLC”) has quickly become one of the most popular corporate vehicles for start-ups and other new ventures – and for good reason.  While there are some drawbacks (such as the number and type of investors permitted, and limitations on going public), the LLC combines the tax advantages of a partnership (no corporate level tax) with the limited liability of a corporation (no liability for the individual shareholders or, in the context of an LLC, “members”).

Too Easy?

In addition, the formation process for LLC’s is generally easier than a corporation, with fewer documents required and less formality.  However, the ease involved in forming an LLC can cause some founders to overlook what is, ultimately, a crucial step in the process: drafting and entering into an operating agreement by and between the members of the LLC (an operating agreement is akin to a hybrid shareholder agreement/bylaws for a corporation).

It is not uncommon to be approached by a client, or prospective client, with a crisis of sorts: a fellow member of an LLC is not pulling his or her weight, or has a different vision for the business going forward, and the client wants to know the process for removing that member or dissolving the LLC.  However, with a surprising level of frequency, when we ask what procedure the operating agreement establishes for such scenarios, the client admits that there is no operating agreement in place.

This is a serious oversight.

Decisions, Decisions, Decisions

One of the key aspects of the LLC that the operating agreement should establish is the decision making process.  For example: (1) will there be a managing member, or managing members, that will control the day-to-day operations of the LLC; (2) will there be two or more classes of members, with some having voting rights and others not; (3) will major decisions require a vote of all of the members – and then, will a majority suffice, or will there be a supermajority or unanimous vote required for certain major decisions (such as admitting new members or issuing new membership interests); and (4) what happens if there is a deadlock amongst the members – with a vote evenly split (in such circumstances, a “show-down” provision could be used to break the tie vote).

In a related sense, it is also recommended that dispute resolution provisions, as well as a procedure for removing problematic members (or buying them out), be included in the operating agreement for when disagreements rise to the next level and become more contentious.

Money Matters, Roles and Competition

Other key provisions that should be set forth in an operating agreement address issues of taxation, valuation of assets/contributions by members and the procedure for distributing profits to the members.  Further, the members might want to spell out each member’s role, duties and responsibilities in connection with the business that will be engaged in by the LLC.  Lastly, the members of a new LLC may want to memorialize certain non-compete provisions in the operating agreement in order to prevent members from engaging in businesses that compete with the LLC during their tenures as members, and for some period after they leave.

Customizated Operating Agreement Recommended

Please note that this is only a brief overview of some of the issues that should be addressed in an operating agreement, or at least considered while drafting that agreement.   The specific provisions contained in an operating agreement will inevitably vary depending on the intended relationship between the members, the nature of the underlying business and the complexity of the investment options for prospective members.

It is highly recommended that you retain qualified legal counsel to ensure that any operating agreement that you use, or agree to, provides adequate levels of protection to safeguard your investment of time and money, as well as other interests, while anticipating potential conflicts and other contingencies.