When a client comes to me with the desire to form a Limited Liability Company (“LLC”), one of the first things we discuss is their Operating Agreement. This is by far the most important document to include in your LLC formation, and can alleviate many common stressors before they materialize.
What is an Operating Agreement?
An Operating Agreement is an agreement among the members (owners) of an LLC. It should address the relations among the members (e.g. who are the managers, ownership interests, voting rights, etc…) and how the LLC will conduct its business affairs.
In Maryland, and many other states, the Operating Agreement is not required to be in writing (See MD Corp & Assn Code § 4A-402). However, to mitigate disputes that may arise, it is highly suggested that the agreement be in writing.
Why is an Operating Agreement necessary?
· To document agreed-upon sets of rights, obligations and procedures to refer to in the event of dispute.
· To reduce the likelihood of dispute.
· If potential circumstances and/or issues are not in writing, they will be decided by default based on the laws of the state in which the LLC was formed and/or implied from the circumstances of how the LLC was operated.
· If a dispute arises and there is no Operating Agreement, the Court may resolve by ordering a dissolution of the LLC.
What should be included in my Operating Agreement?
Key points that should be addressed in your Operating Agreement are:
1. Management. The Operating Agreement should identify the manager(s) of the LLC and specify the extent of the managers’ powers to bind the LLC (i.e. what can the manager do without member approval). Typically, a growing business will want to assign certain powers to the managers to keep the business’ processes agile and reduce potential bottlenecks. Where member approval is required, the Operating Agreement must further specify, for each type of action, whether unanimous, majority, or super-majority approval is required.
2. Transfer and/or Assignment of Membership Interest. The Operating Agreement should address procedures for, and restrictions on, transfer and assignment of membership interests. The agreement should further address situations such as the withdrawal, death, or removal of a member. It is common for transfers to people outside of the initial LLC formation to be prohibited in order to preserve the close relationship of the members and ensure that all members remain comfortable with the ownership of the business (e.g. bringing in a 3rd party “stranger” may adversely impact the business). If transfers are not prohibited, the Operating Agreement should specify the procedures governing the transfer and/or assignment of Membership Interest. Generally, the other members reserve the right of first refusal to purchase the selling member’s interest on the same terms as the bona fide offer from the third party.
3. Actions by the Members. The Operating Agreement should consider the actions the members may take on the LLC’s behalf. Things to consider in the Operating Agreement are: voting rights, member meetings, participation requirements, and who has power to bind the LLC.
4. Capital Structure. The Operating Agreement should specify the Capital Structure of the LLC. Namely, who made what initial capital contribution to the LLC and their corresponding ownership interest in the LLC. Failure to specify capital contributions and ownership interest will result in defaulting to the laws of the state in which the LLC was formed, which could yield an undesirable result for one or all members. The Capital Structure should also specify how profits and losses will be allocated amongst the members.
5. Dissolution of the Company. The Operating Agreement should address the situations in which dissolution of the LLC would occur (called “liquidation events”), member responsibilities during dissolution, and the process for distributing liquidated assets.
6. Amendments to the Operating Agreement. An Operating Agreement should specify who needs to consent to an amendment for it to be binding on the LLC (i.e. unanimous decision, majority of members, or super-majority of members). In Maryland, if the Operating Agreement does not provide for the method by which the Operating Agreement may be amended, then all members must agree to any amendment of the Operating Agreement.
Do I need an attorney to draft my Operating Agreement?
In general, you should hire an attorney to draft your Operating Agreement. Your attorney will help you address the subtle intricacies of the agreement and ensure that you are provided the necessary protections. It also helps to have your attorney work with all the LLC members to ensure that members’ rights and responsibilities are well defined and reasonably communicated in the document, should a dispute ever arise. If you will be forming a single-member LLC (i.e. no other members, investors, or employees), then a simple operating agreement from a commercial source may be sufficient. The Reddix Firm offers basic Operating Agreements in our store, as well as Operating Agreements that are drafted specifically for your business.
Have questions? Contact me at email@example.com or (443) 776-8516.