Contract Clauses, LLC, Small Business

5 Key Provisions for Your LLC Operating Agreement

August 20, 2019August 20, 2019
5 Key Provisions for Your LLC Operating Agreement

Successful incorporation is a major milestone for any business owner.  In one sense, it’s is an indication of a stable and successful operation.  Additionally, the benefits gained from incorporation are nontrivial: owners that incorporate their business gain an invaluable layer of protection, as their businesses is from thereon treated as its own separate legal entity.  

Perhaps unsurprisingly however, there are some “strings attached” to business incorporation.  Namely, incorporated businesses are subject to a number of formalities and rules that don’t apply to unincorporated entities.  Many of these rules are self-established through the company’s formation documents.  In other words, owners will draft and file their own formation documents, which they are then required to comply with.

This isn’t an insurmountable task, but it can be difficult to determine which formation documents apply to you and what provisions to include.  Does this mean that business owners are better-off not incorporating?  Very likely not, as the benefits associated with incorporation usually outweigh the negatives.  However, it does mean that owners interested in incorporation must first identify which formation documents to file, then decide what provisions to include.  

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Which Formation Documents Apply to My Business?

Business incorporation can be seen as a two-step process: first an incorporated business entity is chosen (usually an LLC, a Corporation, or a variation of the two), then the appropriate formation documents are drafted and filed.  Determining the best business entity is often the more challenging of the two tasks and generally requires consultation with a business attorney.  

For the second task, the formation documents that apply to your company will depend on the chosen business entity and the state in-which you’ll do business.  For owners looking to form an LLC, this documentation will usually include the Articles of Formation and the LLC Operating Agreement.  

The Articles of Formation typically contain the business’s basic identifying information, like its name, its employer identification number, the location, and the owners’ contact information.  On the other hand, the LLC Operating Agreement includes more in-depth information regarding the business’s rules, procedures, and ownership structure.  In many ways, the Operating Agreement is a contract made between the company and its owners, and thereby establishes the ground-rules for the new LLC.

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5 Provisions to Include in your Operating Agreement

There’s no standard Operating Agreement that will work across the board. Different LLCs will have different terms and provisions depending on the particulars of their business, ownership structure, and location.  Even LLCs providing similar services in the same state won’t have identical Operating Agreements.  

For this reason, it’s crucial that owners know what to include in their agreement before filing with the state.  While these documents are indeed case-specific, there are some provisions that should always be considered:

1. Member Roles and Responsibilities

In the context of an LLC, a member (also sometimes called an owner or a shareholder) is simply an individual with equity in the company.  Each member will have their specific role in the operation of the business, and these responsibilities should be clearly outlined in the LLC Operating Agreement.  Should members wish to allocate day-to-day responsibilities to a non-shareholder manager (also called manager-managed, as opposed to member-managed), this should also be detailed in the agreement.  

2. Distributions

It’s very important to define how profits and losses will be passed-through to LLC members.  The allocation of distributions is usually done in accordance to each members’ percentage ownership; members who own more shares will have more financial responsibility.  In addition to how profits/losses are divided, a strong LLC Operating Agreement will specify exactly when distributions are made as well.

3. Classes of Interest

Although all members of a given LLC are indeed part-owners, there can be special “classes” of members.  Different classes have different rights in terms of voting power and financial entitlements.  Not all LLCs have classes, but if they do, it’s critical to unambiguously define them in the LLC Operating Agreement.

4. Books and Recordkeeping

LLC members are required to obey a number of formalities, which includes thorough record keeping and reporting.  Failure to maintain complete records can lead to revocation of their “LLC” status, thus loss of asset security and personal liability protection.  The LLC Operating Agreement should establish how this documentation will be kept as well as who is responsible for maintaining it.  

5. Dissolution

Lastly, it’s important for the LLC Operating Agreement to establish the protocol for company dissolution.  This provision should specify which events could trigger dissolution and detail the members that can make this determination.  

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These provisions are important to include in your LLC Operating Agreement, but are by no means comprehensive.  A strong Operating Agreement may also include language on equity transfer, anti-dilution protections, dispute-resolution provisions, member departure protocols, and more. 

Also worth noting, once the Operating Agreement is filed and approved by local state officials, it can be difficult to modify, supplement, or amend.   An experienced attorney can help assure that your agreement is complete, strongly-written, and unambiguous before filing.

Lastly, it’s important to consult your local state agencies.  While most states require the Articles of Formation, only some will require the Operating Agreement.  States that don’t require a written Operating Agreement tend to request more in-depth information to be included in the Articles of Formation (or sometimes in a separate filing).  It’s simply a matter of local regulations, but again, a legal professional can help clarify the state-specific requirements for proper LLC formation.  

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