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Operating Agreement:
A Key to an Effective LLC

While the members are on good terms, spelling out the essentials of how the business will function can minimize costly legal issues when something goes wrong down the road

John McKindles

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In a multi-member limited liability company (LLC), at least three powerful reasons justify creating an effective operating agreement while the LLC is in its infancy:

First, drafting an agreement is relatively easy to accomplish when all of the members are on good terms and have similar objectives.

Second, a properly drafted operating agreement can help you achieve the liability protection that contributes to the popularity of the LLC form of entity.

Third, if you are making any tax-related elections, such as choosing to be taxed as an S corporation, clearly mentioning that in your operating agreement can help you achieve your desired tax benefits and protect you from the IRS.

(Note: Items 2 and 3 are important whether the LLC is multi-member or single-member.)

Nevertheless, many owners overlook or disregard the thoughtful creation of their operating agreement. The Arizona Corporation Commission does not require it; business owners often are so caught up in getting their venture off the ground that “nice things” like operating agreements never work their way to the front burner; and, too often, all of the members fully expect that any disputes that could possibly erupt will be minor and easily resolved. This starry-eyed perspective can prove to be expensive later on.

Tips for Drafting Your Operating Agreement

As was mentioned above, the time most likely to evoke agreement among the players is at the beginning. If you wait until the inevitable friction occurs, “good luck” in reaching agreement. Also, clearly writing out the manner in which issues will be resolved, allocating responsibility and authority, structuring exit strategies, etc., will more quickly reveal whether you are all on the same page before everyone gets heavily invested in proceeding.

You can make the operating agreement as simple or as complicated as you wish. Essentially, it would be wise to consider addressing at least the following areas in the agreement.

Term. Most people use a perpetual mode for the entity term, but you may have reason for a shorter or more specific term, depending upon the purpose of the LLC.

Purpose. Here you can more specifically define the LLC’s agreed objective.

Additional Members. Describe whether the LLC will allow additional members and, if so, the procedure to be followed to do so.

Capital Contributions. Specify how much money or other consideration is to be contributed to start the LLC by the members. Also, describe the procedure for any additional contributions if needed later on.

Profits, Losses, Distributions. Here you describe how profits are to be handled, losses to be allocated (not necessarily in the same proportion as profits) and any other particular distributions.

Tax Treatment. Generally, LLC tax treatment acts as a pass-through, similar to a partnership, to the members. However, there may be other factors compelling a different type of treatment.

Management Responsibility/Authority. This is a critical matter to be considered and clarified. How are decisions to be made? Who makes them?

Powers of Members. Describe the extent of authority of members to make decisions or take action.

Duties of Members. Here, specific responsibilities can be outlined together with a procedure to follow in the event that duties are not being carried out. This needs serious consideration and specificity, since it reveals just what the members expect from each other.

Dispute Resolution Process. Determine and describe how disputes are to be resolved. Majority vote? Majority of members or interests held? Two-thirds majority? If this process does not resolve the issue, have a back-up process such as mediation and arbitration.

Compensation. The members can specify whether and how much any of them may be compensated for any services provided to the LLC. There may a disparity in the level of services provided that should receive a commensurate compensation, and this is where such terms would be reflected.

Transfers. Procedures should be spelled out in the event a member desires to sell or otherwise transfer a membership interest. This clause normally includes rights of first refusal and buy-sell provisions.

Valuation of Exiting Members Interest. Members should agree in advance as to determining the value and compensate for an effective redemption of an existing member’s interest in the event no buyer then exists.

Procedures for Dissolution. Here place the description of terms and procedures to be followed in an agreed or contested dissolution of the LLC.

conclusion

These are just some of the issues that an LLC operating agreement should address. Reliance on a handshake is risky business, even if every member has unimpeachable integrity, as any two people can all walk away from a handshake with differing understandings of a verbal discussion. The modest investment in time and money to promptly document these business procedures will pay huge dividends in the event of disruptive disagreements.