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