What is an Operating Agreement?
An Operating Agreement is a legal document that outlines the ownership and member duties of your Limited Liability Company. An Operating Agreement allows you to set out the financial and working relations among business owners (“members”) and between members and managers.
What does an Operating Agreement contain?
The core elements of an LLC operating agreement include provisions relating to equity structure (contributions, capital accounts, allocations of profits, losses and distributions), management, voting, limitation on liability and indemnification, books and records, anti-dilution protections, if any, restrictions on transfer, buyouts, dissolution and liquidation, confidentiality and restrictive covenants, and general provisions such as governing law and dispute resolution.
Below is some information on Equity Structure, Management, Voting, and General Provisions.
(a) Membership Interest. A member’s membership interest is often expressed as a percentage interest. It can vary as new members are added.
(b) Classes of Membership Interests. Given the flexible capital structure of LLCs, it is possible to create the equivalents of equity structures of partnerships or corporations. An LLC can have non-voting interests, common interests, preferred interests, convertible interests, profits interests, etc.
(c) Contributions and Capital Accounts. Each member has a capital account. Initial percentage interests are determined based upon value given to initial capital contributions. A member’s capital contribution to the LLC may take the form of cash, property, services rendered, a promissory note, or some other obligation to contribute cash or property or to render services, or any combination of the foregoing. Members need to address in the operating agreement whether there will only be initial capital contributions, or whether members will be asked to make ongoing contributions or there will be potential future capital calls.
(d) Allocation of Profits, Losses, and Distributions. The operating agreement may alter the default rule of proportionate allocation of profits, losses, and distributions among members. The operating agreement may provide each class of units with unique economic rights and may even alter the allocation rules between members of the same class.
An LLC may be managed by members or managers. If LLC is manager-managed, this section of the operating agreement would describe the appointment of managers (which members may appoint), the nature and frequency of manager meetings and voting procedures, duties and responsibilities of managers, term, and procedures for manager removal and replacement.
The operating agreement may alter the standard rule that members vote in proportion to their percentage interests. It can even withhold entirely the voting right of a member or class of members to vote upon any matter. Voting rights can also be determined on the basis of capital contributions, capital commitments or capital accounts. Also, certain members or managers can have veto rights or supermajority votes. For example, a class may not have general voting or managerial rights, but have veto right on certain actions to be taken by the managers.
Last but not least, the general provisions can include a provision requiring members to settle disputes first through non-binding mediation, followed by binding arbitration. There should also be a provision regarding required vote to amend the operating agreement (perhaps, a vote by managers and a certain percentage of members).