Important Provisions for LLC Operating Agreements
by Peter Smith
In our day-to-day practice, we see a lot of Limited Liability Companies that have been formed online or through the purchase of a package of documents. It is understandable as these outlets often provide a cheaper and faster road to incorporation than using the more traditional law firm approach.
The primary issue that I have noticed when speaking with LLCs that have been formed in this manner is a general lack of understanding and follow through as to the corporate governance surrounding these companies. When it comes starting a new company, there are a lot of new and exciting aspects of the process and unfortunately, corporate governance isn’t one of them. As a result, it often times gets swept aside in lieu of more interesting and challenging aspects of the launch.
The problem with this is that while it is not the sexiest or most exciting aspect of any company – corporate governance is extremely important. When it comes to LLCs, the Operating Agreement is perhaps the single most important document the Company will ever create, as it is the contract that binds the members together and governs how they will operate the company.
Thus, if you are contemplating starting an LLC and want to avoid overlooking an extremely important aspect of the formation process, make sure to be cognizant of these issues when getting started and creating your first operating agreement:
1. Dispute Resolution
Most standard operating agreements do not include language surrounding dispute resolution. This means that any dispute amongst the members of the LLC surrounding the operation of the company generally has to be resolved informally (ie – over a bottle of wine at dinner), or through civil litigation in the local court system. While informal resolution can be effective when everyone involved in the dispute is committed to finding a resolution, civil litigation can be a lengthy and costly process and is generally the least efficient means towards resolving a dispute. Accordingly, I always like to include language for alternative dispute resolution measures such as Mediation and Arbitration in the operating agreement.
While these mechanisms are by no means perfect (and can certainly also be expensive when you consider legal fees), they can help expedite a resolution to any serious dispute, and having a designated roadmap towards resolving disputes is always a positive in my opinion.
2. Equity Allocation
Of course it is important to determine who owns the equity in a limited liability company. The issue is, however, that the designation of ownership is often given little or no thought in the initial documents. Many times we will simply see percentages next to names as the only means of determining who owns the Company.
While establishing your percentage ownership in your company is important, I’d recommend using membership units as a quantifiable method of allocating equity. If each founder/member is designated a certain number of membership units, future equity issuances can be accomplished more easily and with a better understanding of where each member will sit after the new issuance (ie – how much has their equity been diluted).
3. Capital Contributions
Capital contributions are an extremely part of a limited liability company. The initial capital contribution is what gets an LLC off the ground (generally cash, property, or sweat equity), and additional capital contributions may be needed to help the company continue operations once it is formed. Having very clear language surrounding capital contributions, and how they are made, is a must. Questions that should be answered by the Operating Agreement are:
• Who gets to decide when additional capital contributions are necessary?
• Are additional capital contributions mandatory or voluntary?
• What happens if one member makes an additional capital contribution and another refuses?
Limited liability companies can be governed by their members or by a designated manager. It is vital for newly formed LLCs to have clear language in their operating agreement that designates how management of the company is to occur. One of the issues we see most often is a dispute amongst members over who is in charge of making what decisions.
It can be hard when a company is just formed to sit down and clearly delineate management responsibilities. The natural inclination is to go with the, “well – let’s just figure it out as we go” mentality. That can be very dangerous, however, and lead to situations where management disputes impede the company’s day-to-day operations and harm the personal relationships between the members. Have those difficult conversations early and make sure that it is very clear where responsibility is being delegated.
5. Transfer Restrictions
The concept of transfer restrictions for a member’s equity in an LLC is often something that first time entrepreneurs have not considered. Put simply – transfer restrictions (also called “right of first refusal”) can be put in place to ensure that no member goes out and sells their equity in the company to a third party, without at least giving the other members (or the Company) the chance to purchase that equity themselves.
This can be very important in situations where a small, closely held, company has only a few founders/members. Those individuals may not want to share equity with an unknown third party and so in those instances, it is good to have language in place to allow those members to keep everything in house.
January 27, 2020