Two Reasons to Adopt an LLC Operating Agreement
The LLC (limited liability company) is an excellent option for business owners who want flexibility with a minimum of state-required recordkeeping formalities, such as the need to adopt bylaws and hold annual meetings. However, just because formal agreements among the owners are not required, it can be a painful and costly mistake to rely on the default state law provisions to spell out the LLC’s operating rules.
Default Provisions Are Not Comprehensive
Every state has provisions governing LLCs—but every state has its own peculiarities. While few people enjoy wading through the details of state business laws, every business owner must know one critical fact: state statutes establish the default provisions for an LLC. These provisions will control how the LLC is structured and operates.
As an example, consider the LLC’s management structure. In general, an LLC can be managed by all of its members or the members can vest management power in one or more managers” In most states, the default form of management is member-managed. This means that all the members must agree on all the business decisions. It also means that all members have the authority to bind the LLC by entering into contracts with third-parties.
Most states’ default provisions do address all of the issues that will arise during the course of business operations. For example, few state laws spell out how LLC interests must be valued when a member seeks to exit the company or redeem equity when he or she becomes disabled.
The LLC operating agreement can override many of the default presumptions. Among the issues that an operating agreement should address are
- how the LLC will be managed —by its members or by managers (who may or may not be members)
- how the management team will be selected
- how key business decisions will be made
- what actions require a vote by the members (and what percentage is required for approval)
- what are the duties and responsibilities of the members
- how are profits and losses allocated among the members
- what is the procedure for transferring ownership interests or bringing in additional members
- what triggers the disassociation of a member
- what events (if any) will trigger dissolution of the company
Adopting an operating agreement ensures that the company operates the way the members wish.
Default Provisions Can (and Do) Change
Suppose you are fine with your state’s default provisions. Why bother to draft (or have an attorney draft) an operating agreement? The much-touted flexibility and freedom of the LLC often lulls business owners into thinking that they can save the expense and aggravation of adopting an operating agreement. But this often turns out to be short-sighted.
An operating agreement allows you to "future-proof" your company. When (not "if") the law changes, your LLC may find itself operating under rules that the members did not envision when the company was created. In any given year, over a dozen states amend their laws. Some of these changes are small, but others can have a significant impact on LLC’s formed or operating in that state.
Here are some recent law changes that will impact LLC’s operating under state default provisions.
- Alabama. Changes to Alabama’s LLC statutes require that every LLC has an operating agreement—but it can be written, oral or implied. This means that courts can infer what members meant from their actions. Having a written agreement will save much pain and expense when (not if) problems arise.
- Florida. Florida amended its statutes to apply common law fiduciary principles to the standards of duty and care owed by both members and managers of an LLC. While sounding innocuous to most people, these fiduciary duties are often at the heart of lawsuits by disgruntled members. Using the operating agreement to delineate the standards for your LLC is excellent preventative medicine.
- California. California LLCs may also find their management changed by amendment to the LLC law that took effect at the beginning of this year. Decisions that are outside the normal course of business now require unanimous approval of all the members. California LLCs can avoid these restrictions by adopting (or amending) an operating agreement that enumerates the authority of the managers and describes what is considered an extraordinary transaction.
- New Jersey. If a member resigns from an LLC, the member is no longer has the right to receive the fair value of the membership interest. Instead, the member loses membership rights—but retains the rights of an economic interest holder. An operating agreement would enable a resigning member to “cash-out” the membership interest.
Adopt and Proactively Review an Operating Agreement
State default provisions can conflict with the LLC members’ vision of how their company should operate. Plus, they seldom—if ever—address all of the issues that can arise throughout the life cycle of any business. And, default provisions can change, creating an unpleasant surprise for the complacent.
The only way to guarantee that LLC functions as the members want is to adopt an operating agreement that covers all the essential areas, from management to financial. Once adopted, the operating agreement should also be reviewed on an annual basis to ensure that it still reflects the member’s wishes and addresses all areas where the members want to override the default provisions of state law.
Drafting such an agreement requires knowledge of the laws of the state—both statutory and common law. Nuances that a layperson might overlook can have a significant impact on the company’s operations and the members’ responsibilities. For this reason, it is wise to consult with a business attorney who is well-versed in the state law draft the agreement.