How to Draft an Operating Agreement
Careful planning on how to draft an operating agreement for an LLC requires some basic business knowledge and in depth discussion by the members or partners to the agreement.
The people running the business and making decisions really need to sit down and discuss all the issues they think may arise in running their particular business which will go along way in helping them in how to draft an operating agreement.
Most states, including Connecticut refer to the partners in the limited liability company (LLC) as members. There are three basic classifications of people involved in the LLC that you should be aware of when drafting the operating agreement. They are:
- Members
- Managing Members
- Managers
Members are those that have an equity ownership interest in the LLC. This means they own shares in the LLC which are referred to as “membership interests”. If this was a corporation they would be called shares of stock. Members may or may not have an active role in running the operations of the LLC’s business.
Managing Members are those that in addition to have an ownership interest in the LLC are also managers in the sense that they make decisions and help run the business. They may be part-time or full-time and the operating agreement can spell out the different titles they may have such as President, Vice-President, Chief Financial Officer, Chief Strategy Officer or any of the numerous other titles there are to identify a persons position and role in a business.
Managers are those people that do not have an equity ownership in the LLC, but yet help run the business. They may simply be key employees with some management type position or decision making authority or someone appointed President to run the LLC because of their background and experience, but who does not have any ownership in the business so does not share in the profits unless the Managing Members vote to reward that manager with a portion of profits as part of that person’s pay structure.
The people running the business and making decisions really need to sit down and discuss all the issues they think may arise in running their particular business which will go along way in helping them in how to draft an operating agreement.
Most states, including Connecticut refer to the partners in the limited liability company (LLC) as members. There are three basic classifications of people involved in the LLC that you should be aware of when drafting the operating agreement. They are:
- Members
- Managing Members
- Managers
Members are those that have an equity ownership interest in the LLC. This means they own shares in the LLC which are referred to as “membership interests”. If this was a corporation they would be called shares of stock. Members may or may not have an active role in running the operations of the LLC’s business.
Managing Members are those that in addition to have an ownership interest in the LLC are also managers in the sense that they make decisions and help run the business. They may be part-time or full-time and the operating agreement can spell out the different titles they may have such as President, Vice-President, Chief Financial Officer, Chief Strategy Officer or any of the numerous other titles there are to identify a persons position and role in a business.
Managers are those people that do not have an equity ownership in the LLC, but yet help run the business. They may simply be key employees with some management type position or decision making authority or someone appointed President to run the LLC because of their background and experience, but who does not have any ownership in the business so does not share in the profits unless the Managing Members vote to reward that manager with a portion of profits as part of that person’s pay structure.
Key Questions to Be Answered When Drafting an Operating Agreement:
Roles and Responsibilities of the Members and Managers.
A short paragraph of two or three sentences can accurately give a title and description of what each member, managing member or manager will be doing for the LLC. Clearly defining the roles of the parties, the hours they will need to put in, and what responsibilities, duties and authority they will have is very important to avoid problems and disputes in the futures. Some may have larger roles than others. Some may get a salary in addition to a share of the profits. There are numerous ways that the parties can structure this, and it is the attorneys job to identify all the different possibilities that exist not only in payment structures, but in all the other sections of the operating agreement as well. To do a thorough job, more than one meeting between the parties and the attorney may be required.
Who Will Have Signing Authority With Respect to the Bank Account and Contracts?
While any managing member has the authority to bind the LLC to contracts and other obligations it is sometimes a good idea to designate one person or two who will sign all contracts that may need to be signed. It avoids confusion and it creates an orderly process on how the business is run. The same is true with the bank account. If you have 5 partners, designate 1 or 2 as signatories and make sure you have checks and balances to monitor all payments going in and out of the bank account. All partners should have access to the accounts even if they do not have signatory power.
Don’t assume the accountant will catch everything. The accountant does know the intricacies of the business in terms of who the vendors are, what are valid payments out of accounts payable and whether or not all payments are in the normal course of that particular business. But the partners will be able to keep a better eye on each other in terms of what is being spent and for what purpose.
Don’t assume the accountant will catch everything. The accountant does know the intricacies of the business in terms of who the vendors are, what are valid payments out of accounts payable and whether or not all payments are in the normal course of that particular business. But the partners will be able to keep a better eye on each other in terms of what is being spent and for what purpose.
Joseph B. LaRocco is a CT business contracts attorney that handles commercial contracts, business transactions, entity formations, corporate formation and corporate governance.
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Voting Rights.
This is very straight forward in in most situations each member has a vote equal to the number of membership interests that the member owns. Exceptions might be if one member has made a large loan or provided some addition benefit to the LLC which until repaid allows that member 51% of the voting rights of the LLC. This is similar to super preferred voting rights that some corporations establish. By the way, voting rights percentages do not have to be equal to equity interest percentages.
Will the Members Draw Salaries or Only Be Paid From the Profits?
If the LLC is a startup venture it will likely start out by paying LLC dividends or draws from the profits until the business can afford to pay salaries. Some LLC’s only pay out profits instead of salaries to the members. If the business is not profitable then obviously no one is getting paid until there is a profit and that is another issue that the members will have to deal with in terms of how to stay afloat and whether or not they are required to make loans to the LLC from time to time.
How Are Decisions to Expand the Business or Make Other Acquisitions Handled?
This can be done by majority vote or unanimous vote but should be spelled out in the operating agreement. Never assume the managing members are in agreement and have the same vision for the company. If it is not in writing, then it only leads to arguments and confusion later on in the business. If expansion plans can be covered in the operating agreement then there doesn’t even need to be a vote on the matter because it has already been agreed upon. How to draft an operating agreement means you have to ask a lot of questions of the parties involved to solve problems before they happen by drafting a document that covers as many bases as possible.
For instance, if the LLC runs a truck rental business, the operating agreement can require that all profits above a certain amount go toward the purchase of additional trucks, so the business maintains at least 10 trucks at all times. This way everyone is one the same page in terms of growth and they all have a common goal. In the event things change for whatever reason, the managing members can always vote to amend the operating agreement to reduce the number of trucks to 8, or increase the number to 12, but at least in the beginning they all have agreed to grow the business with a goal of 10 trucks on hand.
For instance, if the LLC runs a truck rental business, the operating agreement can require that all profits above a certain amount go toward the purchase of additional trucks, so the business maintains at least 10 trucks at all times. This way everyone is one the same page in terms of growth and they all have a common goal. In the event things change for whatever reason, the managing members can always vote to amend the operating agreement to reduce the number of trucks to 8, or increase the number to 12, but at least in the beginning they all have agreed to grow the business with a goal of 10 trucks on hand.
Are the Members Required to Loan the LLC Money?
While loaning money to the company as a requirement may seem harsh, if the company is a startup, there is a very good chance it will need additional funding or financing during its initial stages until it becomes profitable. Even if it is profitable it may need money to expand but might not be able to get investor funding or financing. In situations like that it is not uncommon for members to put in additional capital, which can be done in a few different ways.
Rather than making it mandatory that members must loan or make additional capital contributions to the LLC it can be made discretionary. The next question though is whether or not members putting in additional capital get a larger percentage ownership in the LLC or if it is just a loan that the LLC pays back from profits.
The LLC members really need to discuss this issue carefully since some members might no be able to financially commit to making additional capital contributions, yet don’t want other members to make capital contributions and dilute their ownership percentage. It is a very touchy subject and something that should be worked out in advance rather than when it is problematic, and the members cannot agree so the business ends up failing and everyone loses.
Rather than making it mandatory that members must loan or make additional capital contributions to the LLC it can be made discretionary. The next question though is whether or not members putting in additional capital get a larger percentage ownership in the LLC or if it is just a loan that the LLC pays back from profits.
The LLC members really need to discuss this issue carefully since some members might no be able to financially commit to making additional capital contributions, yet don’t want other members to make capital contributions and dilute their ownership percentage. It is a very touchy subject and something that should be worked out in advance rather than when it is problematic, and the members cannot agree so the business ends up failing and everyone loses.
How Will Competing Business Interests and Conflicts of Interests be Handled?
Each of the managing members of the LLC as officers and/or directors owe fiduciary obligations to the other managing members. Based on these fiduciary duties they cannot take other jobs or enter into arrangements to the detriment of the LLC or that would take business away from it. If there is any question the managing members have about what they can and cannot do they should be discussed and once agreed upon stated in the operating agreement.
Some competing interests or conflicts of interest may include what other businesses can they own and operate. Another important issue is whether or not a managing member can do similar business with a customer of the LLC. Some of it may just seem like common sense, but nothing should be assumed in a day and age when business relationships can be very complex and have conflicts that not all the business partners agree upon.
Some competing interests or conflicts of interest may include what other businesses can they own and operate. Another important issue is whether or not a managing member can do similar business with a customer of the LLC. Some of it may just seem like common sense, but nothing should be assumed in a day and age when business relationships can be very complex and have conflicts that not all the business partners agree upon.
What if a Member Defaults in His or Her Duties, Can They Be Bought Out?
This is usually one of the trickier subjects to deal with because some of it is subjective and some managing members just worker harder than others and expect everyone to keep pace with them regardless of how many kids they may have or other family commitments. If one of them is not pulling their wait it ends up in arguments and disputes that cannot easily be settled. One way to handle it may be that each member is required to put in a certain number of hours, but depending on the type of business it is, that can be easier said that done.
How Are Disputes Among the Members to Be Resolved?
There are a few ways to handle disputes and it really depends on the parties, how many managing members there are, what their roles are and what kind of dispute it is. If it is simply a matter of the parties trying to decide on a certain course of action, business strategy or new product to manufacture then it seems a vote among them can solve the problem. On the other hand, if it is a dispute regarding one of the members not pulling their weight and putting enough time into the business, that is when it becomes a problem and a simple vote might not fix the problem.
Extreme measures can and should be spelled out in the operating agreement for a managing member that steals from the company or commits some other defined “offense” that calls for a vote and an ouster of that person. Whether it is a Connecticut operating agreement or one drafted for another state, that agreement should carefully spell out all the steps, what percentage vote is required and what the ousted managing member is paid if anything. If that person made a loan or has not gotten back the capital contribution that was put into the company to get it started, then the operating agreement should clearly state if they get that money back.
Another important factor for the members or solo member of an LLC to consider is the Exit Strategy Considerations for an LLC. Is the LLC going to be sold in the next 5 to 7 years, will it be merged into another entity, or will it simply close down. These are all important considerations since being able to sell a business you worked hard at to build up into a sellable asset, can be very valuable. Even if you can't sell the limited liability company you can market the business for sale to interested buyers and structure it as an asset purchase. Many buyers prefer an asset sale to a corporate sale for a number of reasons.
There are a numerous issues that are involved when two or more parties get together to establish a business relationship, form an entity like an LLC and agree on a written contract such as a CT operating agreement. The operating agreement is sometimes a boiler plate agreement obtained from the internet and not carefully reviewed or changed to fit the particular needs of the business and its partners.
The operating agreement is a very important document because it will govern their rights and responsibilities as well as profit splitting, guidelines on borrowing money, taking on additional partners, resolving disputes and ultimately an exit strategy. If you don't know how to draft an operating agreement for your limited liability company, don't be afraid to seek legal advice. What you spend on legal fees to have a solid agreement will save on legal fees if there is a dispute which cannot be settled based on the flimsy operating agreement the partners signed. I make it a point to really get to know what type of business is involved and how the parties intend to manage and grow the business. By really understanding the business and the parties involved an attorney can then do a proper job on how to draft an operating agreement for his or her clients.
Each operating agreement should be tailored to the specific business and the specific needs of the parties involved. I do not recommend using a boiler plate form found on the internet, although that may be a good starting point to do some research before contacting an attorney to set up a meeting and have your operating agreement drafted.
Extreme measures can and should be spelled out in the operating agreement for a managing member that steals from the company or commits some other defined “offense” that calls for a vote and an ouster of that person. Whether it is a Connecticut operating agreement or one drafted for another state, that agreement should carefully spell out all the steps, what percentage vote is required and what the ousted managing member is paid if anything. If that person made a loan or has not gotten back the capital contribution that was put into the company to get it started, then the operating agreement should clearly state if they get that money back.
Another important factor for the members or solo member of an LLC to consider is the Exit Strategy Considerations for an LLC. Is the LLC going to be sold in the next 5 to 7 years, will it be merged into another entity, or will it simply close down. These are all important considerations since being able to sell a business you worked hard at to build up into a sellable asset, can be very valuable. Even if you can't sell the limited liability company you can market the business for sale to interested buyers and structure it as an asset purchase. Many buyers prefer an asset sale to a corporate sale for a number of reasons.
There are a numerous issues that are involved when two or more parties get together to establish a business relationship, form an entity like an LLC and agree on a written contract such as a CT operating agreement. The operating agreement is sometimes a boiler plate agreement obtained from the internet and not carefully reviewed or changed to fit the particular needs of the business and its partners.
The operating agreement is a very important document because it will govern their rights and responsibilities as well as profit splitting, guidelines on borrowing money, taking on additional partners, resolving disputes and ultimately an exit strategy. If you don't know how to draft an operating agreement for your limited liability company, don't be afraid to seek legal advice. What you spend on legal fees to have a solid agreement will save on legal fees if there is a dispute which cannot be settled based on the flimsy operating agreement the partners signed. I make it a point to really get to know what type of business is involved and how the parties intend to manage and grow the business. By really understanding the business and the parties involved an attorney can then do a proper job on how to draft an operating agreement for his or her clients.
Each operating agreement should be tailored to the specific business and the specific needs of the parties involved. I do not recommend using a boiler plate form found on the internet, although that may be a good starting point to do some research before contacting an attorney to set up a meeting and have your operating agreement drafted.
How to Add or Remove New LLC Members
There are many other factors for consideration on how to draft an operating agreement. Every business is different and has their own nuances based on the relationship of the managing members, their backgrounds and how they feel the business should be run. Taking the extra time to understand the business and the needs of the partners is an important aspect of how to draft an operating agreement properly.
