A Limited Liability Company (LLC) is a type of incorporated business structure that’s treated as a separate legal entity, distinct from its owners. This distinction provides a layer of protection for owners, which is perhaps the single most attractive attribute of LLCs and other types of incorporated entities. By incorporating a business, an owner is legally distinguishing their personal assets from their business assets. In other words, the liability of the business—which might include things like debts, legal claims, and other financial obligations—are disjoint from the owners’ personal accounts.
However, there is a minor catch; for an LLC to be granted “corporate-status”, owners must first file the appropriate formation documents with their local secretary of state’s office. Filing the required documentation isn’t necessarily a challenge but can be an inconvenience for owners, especially in terms of drafting their LLC Operating Agreement.
Depending on the state, most businesses looking to form an LLC are first required to file an LLC Operating Agreement. This contract basically establishes the rules and protocols of the business (even in states that don’t require an Operating Agreement, these rules and protocols must be stated elsewhere, oftentimes in an LLC’s Articles of Formation or a separate filing). The Operating Agreement is a foundational document for any LLC; it’s essentially a contract between the LLC and its owners. The agreement establishes things like general management protocols, information regarding owners’ rights, terms and conditions for distributions, and procedures for company dissolution.
Some LLC Operating Agreements will also contain what are called “Classes of Interests” or “Membership Interests”. It’s important to understand these terms before filing your LLC’s Operating Agreement, as they will likely have profound consequences on ownership structure and members’ rights.
Classes of Interests Explained
Some LLCs are owned my one single individual—these are sometimes called single-member LLCs. More commonly, LLC ownership is shared among multiple owners, who in this context are also called “members”. By definition, each member of an LLC has some ownership stake in the company. However, these stakes don’t necessarily have to be equal.
For example, if an LLC consists of four members, ownership could be split evenly, in which case each member would retain one-quarter ownership of the company. It’s important to note though that LLCs are comparatively flexible, and equal distribution of ownership isn’t required. While Corporations are subject to more rigid ownership rules, LLCs can differentially split ownership among members. This can lead to different groups of members with different rights and responsibilities, which are then sometimes referred to as “classes”.
When LLCs have different ownership classes, each individual member is assigned a class, which is established (in-writing) within the LLC Operating Agreement. By convention, classes are named alphabetically, where the first class is “Class A”, followed by “Class B”, and so on.
Most LLCs don’t have different classes, so why would “classes of interests” appeal to some business owners and not others? Although it’s up to the discretion of those drafting the Operating Agreement, establishing distinctive classes of interests can be a convenient way to group members with different rights. For example, many owners would like founders and investors to have different entitlements, or perhaps want different founders to have different voting powers. In this case, the LLC’s classes of interests may look something like this:
- Class A: Complete Voting Rights and Complete Economic Rights
- Class B: Partial Voting Rights and Complete Economic Rights
- Class C: No Voting Rights and Complete Economic Rights
Here, Class A would be business-founding members with complete voting rights. Class B would also be founders, but perhaps they played a minor role and are thus given less voting power. Class C would be investors, which aren’t given any voting power. All three classes however, are granted economic rights in terms of the distribution of company profits or losses.
LLCs are relatively flexible, meaning that these classes can be defined in almost any way imaginable. Likewise, rights typically involve voting power and/or economic entitlements, but can include other things as well, so long as all members agree to terms before the Operating Agreement is filed.
Nonetheless, classes of interests don’t apply to every LLC. In-fact, most LLCs don’t define different classes in their Operating Agreement either because they are single-member LLCs or more likely because each member is granted equal interests.
Other Provisions to Include in the Operating Agreement
A comprehensive Operating Agreement won’t only establish members’ rights but will define responsibilities and protocols as well. A strong, attorney-reviewed agreement should include language on economic distributions, members’ day-to-day roles, protocols for ownership transfer, protocols for company dissolution, and rules for recordkeeping.
Above all, the Operating Agreement is there to protect you and your LLC. Just like any other agreement, ambiguity can inject uncertainty into the contract and put both your personal and company assets at-risk. For this reason, consulting an experienced legal professional before filing your LLC Operating Agreement is paramount.
Once the Operating Agreement is approved by local state officials, it’s generally difficult to amend or modify. An experienced professional can verify the adequacy of the agreement before it’s submitted to the state agencies.