What are the Key Provisions in an Operating Agreement?
A limited liability company is a business entity structure that limits your liability to the assets invested in the company. As such, if the business is ever sued, the owner or owners of an LLC is/are not personally liable. LLCs were created as many thought that the formalities associated with setting up a corporation were too complex so the administrative burdens of an LLC are more relaxed. One requirement though is that the members (for LLCs the owners are called members rather than shareholders) should create an operating agreement. This is the case even if there is only one member. The operating agreement is a company document that outlines the roles and responsibilities of the members and the organization and governs how the LLC will operate. This is similar to a shareholder agreement but shareholder agreements are drafted for corporations. To see some of the key differences between an LLC and a Corporation click here. This article summarizes the key elements of an operating agreement.
The key parts of a limited liability company ( LLC) operating agreement include provisions relating to ownership structure, contributions, capital accounts, how profit will be distributed, how the company will be managed and who will manage it, how the books and records will be kept, what happens if the company has to dissolve, restrictions on transfer and sale of membership units, confidentiality provisions and other general provisions such as governing law and how disputes should be resolved. We have summarized some of the key elements of an operating agreement and sample provisions below.
A simple operating agreement usually has a general introduction and some “Whereas” provisions that look like this:
This Operating Agreement (the “Agreement”) of [Insert Company Name] (the “Company”), effective [Insert Date] (the “Effective Date”), is entered into [List Members] as the two members of the Company (the “Members”).
WHEREAS, the Company was formed as a limited liability company (”LLC”) on [Insert Date] by the filing of the Articles of Organization with the [Insert State] Secretary of State; and
WHEREAS, the Members agrees that the membership in and management of the Company shall be governed by the terms set forth in this Agreement.
For more complex or longer agreements, there are often long lists of definitions that explain what each term in the agreement means.
The next section usually contains a description of the name of the company, the purpose of the set-up, the general powers of the company and the address of the office and the registered agent. A sample could look like this and note the general nature of the descriptions of the purpose and powers.
Name. The name of the Company is [Insert Company Name].
Purpose. The purpose of the Company is to engage in any lawful act or activity for which limited liability companies may be formed under the Act and to engage in any and all necessary or incidental activities.
Powers. The Company shall have all the powers necessary or convenient to carry out the purposes for which it is formed, including the powers granted by the Act.
Principal Office; Registered Agent.
- Principal Office. The location of the principal office of the Company shall be [Add Address] or such other location as the Members may designate
- Registered Agent. The registered agent of the Company for service of process in the State of [Add State] and the registered office of the Company in the State of [Add State] shall be that person and location reflected in the Articles of Organization. In the event the registered agent ceases to act as such for any reason or the registered office shall change, the Members shall promptly designate a replacement registered agent or file a notice of change of address, as the case may be, in the manner provided by law.
The next section of the operating agreement should describe who the members are and how many membership units they own. This section will also describe the features of the membership units (eg. 1 membership unit equals 1 vote) and will describe any other special features of the membership units. This section usually references a member schedule also that is an appendix to the Operating Agreement. This section should also address how new members should be added (eg. is a vote required) and how the membership unit certificates should be issued. This section can also address restrictions on transfer of the membership units and could include right of first refusal provisions as well as approval and buyout rights.
The next section should deal with how the company will be managed. The section should also describe how officers will be elected and what they can do. This section can go into a fair amount of detail depending on the rights of the various parties but we have summarized a simplified description below.
Authority; Powers and Duties of the Members. The Members shall have exclusive and complete authority and discretion to manage the operations and affairs of the Company and to make all decisions regarding the business of the Company. Any action taken by either Member shall constitute the act of and serve to bind the Company. Persons dealing with the Company are entitled to rely conclusively on the power and authority of the Members as set forth in this Agreement. The Members shall have all rights and powers of a manager under the Act, and shall have such authority, rights and powers in the management of the Company to do any and all other acts and things necessary, proper, convenient or advisable to effectuate the purposes of this Agreement.
When the powers of the managers are more restricted, additional description should be added that specify “reserve powers.” When reserve powers are listed, these items are all items that would require the vote of members in order to do. We have listed a number of typical reserve power items below.
Without the unanimous written approval of all Members, the Company shall not, and shall not enter into any commitment to:
(a) Amend, modify or waive the Certificate of Formation or this Agreement; provided that the Managing Member may, without the consent of the other Member, amend Schedule A following any new issuance, redemption, repurchase or Transfer of Membership Interests in accordance with this Agreement;
(b) Make any material change to the nature of the Business conducted by the Company or enter into any business other than the Business;
(c) Issue additional Membership Interests or admit additional Members to the Company.
(d) Incur any indebtedness, pledge or grant liens on any assets or guarantee, assume, endorse or otherwise become responsible for the obligations of any other Person, except to the extent approved or authorized in the Budget;
(f) Appoint or remove the Company’s auditors or make any changes in the accounting methods or policies of the Company (other than as required by GAAP);
(g) Enter into, amend [in any material respect], waive or terminate any Related Party Agreement [other than the entry into a Related Party Agreement that is on an arm’s length basis and on terms no less favorable to the Company than those that could be obtained from an unaffiliated third party];
(h) Enter into or effect any transaction or series of related transactions involving the purchase, lease, license, exchange or other acquisition (including by merger, consolidation, acquisition of stock or acquisition of assets) by the Company of any assets and/or equity interests of any Person [other than in the ordinary course of business consistent with past practice];
The management section can also address what will occur in the event of a disagreement among members or when the members cannot obtain a consensus view. Finally, this section also usually deals with what happens when a managing member or manager is removed and how this removal can take place.
The next section of an LLC operating agreement usually describes the limited liability that each member has and describes that each member shall be entitled to be indemnified by the company should a party proceed against that member for company business. The operating agreement will also address what happens in the event of a dissolution and how the assets should be distributed. Another important part of the Operating Agreement is the provision that describes how profit is distributed to the members.
Operating Agreements will also address the term of the LLC, how the initial capital is contributed, the tax status of the LLC, and other miscellaneous items such as the governing law.
You should note that the provisions listed above are the very basic LLC provisions and when there are multiple members or other complexities, the agreement has to be carefully drafted to protect the rights of the company and members. Moreover, each State may mandate different LLC Operating Agreement requirements. You should consult with a qualified lawyer to draft this agreement.
Ian E. Scott is a Harvard Law School Graduate, lawyer and author of Law School Lowdown: Secrets of Success from the Application Process to Landing Your First Job. You can access the blog for this book by clicking here. Mr. Scott worked as a corporate litigator in the law firm Cleary Gottlieb and currently runs his own law firm Scott Legal, P.C. specializing in Immigration Law & New Business set-up.
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Ian E. Scott, Esq. is the Founder of Scott Legal, P.C. He can be reached at 212-223-2964 or by email at email@example.com.
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