The LLC Operating Agreement
The LLC Operating Agreement is a key document for a business organized as a New York Limited Liability Company, especially if that business has more than one owner (the owners are “Members” in LLC terminology). If an LLC business was like a marriage, the LLC Operating Agreement would be like a prenup, parenting agreement and divorce settlement all in one.
Why you should have an LLC Operating Agreement
While the New York limited liability company law provides for some default rules applicable to LLC businesses that do not have an LLC operating agreement in place, the members of the business are well-advised to craft their own rules by way of an LLC Operating Agreement (which is actually required by law in New York, Section 417, but there is no official penalty if you don’t have one). The members of the LLC business are given great flexibility to regulate their rights and responsibilities with respect to the LLC, management of the LLC and pretty much everything else that concerns the LLC and the LLC Members. Only very few rules in the NY LLC law cannot be modified by an Operating Agreement.
The LLC Operating Agreement sets forth the rules that apply to the members of the LLC and the management of the LLC. It should give answers to the following questions:
- Who owns what of the LLC business?
- Who contributes what to the business of the LLC?
- Who gets how much of the business profits of the LLC?
- When are LLC business profits to be distributed?
- How are the members to manage the day-to-day affairs of the LLC business?
- Are there specially appointed Managers to manage the LLC business, rather than management by the LLC members?
- Who can vote on non day to day, monumental business decisions affecting the LLC business?
- Who has which responsibilities regarding the business of the LLC?
- What other obligations do the LLC members have to the business and to the other LLC members?
- What happens if an LLC member wants to leave the LLC Business or sell his or her membership interest?
- How can new LLC members join the club?
- Should the LLC members be allowed to force someone to leave the LLC Business?
- How can the LLC be dissolved?
- What happens upon dissolution of the LLC and how are the assets to be distributed?
- What happens upon the death of a Member?
All these and more are questions to be addressed in an LLC Operating Agreement. Ideally, you should hire a business attorney who specializes in startup matters and LLC operating agreements to draft your LLC operating agreement. However, an educated client is the best client, and knowledge of the key issues in an LLC Operating Agreement is key for efficient cooperation with a business attorney.
Management Provisions in an LLC Operating Agreement
Management provisions in the LLC Operating Agreement deal with the management of the LLC business, which basically means decision-making for the LLC business. There are ordinary business decisions (think: buying copy paper at Staples, landing another customer, paying employees….) and extraordinary business decisions, such as obtaining financing for the LLC business, selling major equipment, taking in a new owner, i.e. a new LLC member, merging with another business, and so forth.
Default NY LLC law Rules: Management by Members
As per NY LLC Law, by default, the LLC is managed by its Members (Section 401) and each Member has authority to make ordinary business decisions for the LLC and bind the LLC (i.e. enter into contracts in the name of the LLC) in connection with such ordinary type decisions. Extraordinary business decisions, however, require a formal authorization by the LLC Members (Section 412). The formal authorization can be by a majority vote of the LLC Members in a meeting or by written consent. Buying copy paper is an ordinary business decision. Hiring a lawyer to go against the other business owner is not an ordinary business decision and requires the consent of the majority.
Management by Managers
If you set forth in the LLC’s Articles of Organization (the document that was filed with the Secretary of State in Albany in connection with the formation of the LLC), that the LLC shall be managed by Managers, New York law has a second set of default rules applicable to the management of the LLC. In that case, the Manager(s) have the authority to make ordinary business decisions for the LLC and bind the LLC (i.e. enter into contracts in the name of the LLC) in connection with such ordinary type decisions. Extraordinary business decisions require formal authorization by the Manager(s). If there is more than one Manager, a majority vote or written consent constitutes such formal authorization. In that case, the LLC Members do not have any authorization to manage the day-to-day business affairs of the Company.
However, some extraordinary business decisions still require consent by the LLC Members. The law has a list of such extraordinary events (admit a person as a Member, dissolve the LLC, and so forth, look in Section 402 (c) and (d)).
Drafting your own Rules
When you read the NY LLC law, it almost always states “except as provided in the Operating Agreement…). This is your ticket to draft your own rules with respect to the management of your LLC.
Here are common matters written into LLC Operating Agreements with respect to the management of the LLC business:
No required Annual Meetings
By default, under NY LLC Law, meetings of LLC Members must be held annually. In order to keep the administration of the LLC lean and mean, many LLC founders decide to NOT require annual meetings of the LLC members and state as much in the LLC Operating Agreement.
Board of Managers
LLCs with many Members or Members who are not involved in the day-to-day management of the LLC can provide for a Board of Managers, similar to the structure in corporations.
LLCs can establish committees with responsibilities designated by the Board of Managers, Officers with special titles, such as President, Vice President and others.
In that context, you can provide how many people should be on the Board of Managers and who are the initial persons to serve on the Board of Managers.
You can provide for special veto rights by certain people, how Managers are to be elected, and how they should be replaced or fired, if necessary.
In LLCs with only a few involved LLC Members and no Managers, you would also set forth who of the Members has authority to decide about day-to-day LLC business decisions and bind the LLC in contracts and agreements. You could also provide for certain areas of responsibilities assigned to each managing LLC Member; like Joe is responsible for the LLC’s marketing and Jack for sales and distribution of the LLC.
Retained Voting Rights of LLC Members
You can set forth a list of LLC business decisions that are so important to your LLC that they always require a unanimous vote by the LLC Members, despite management of the LLC by Managers or a few select Members. In that respect, you would also provide the level of consent that is required (majority, supermajority, or unanimous consent) for such decisions.
How many votes does each LLC Member or Manager have when it comes time to take a vote? The default rule for member-managed LLCs under NY LLC Law: The Members vote in proportion to each Member’s share of profits. Example: Joe gave $10,000 as startup capital to the LLC and Jack gave $90,000. Joe gets 10% of all the profits of the LLC and Jack gets 90%. Joe gets 10% of the votes and Jack gets 90%, i.e. in matters requiring majority consent, Jack would always have the last word.
You can change voting requirements for the LLC in numerous ways. There can be special groups of LLC Members who have voting rights different from other LLC Members and independent of their economic interest in the Company. There can even be LLC Members who have no voting rights at all.
Ownership, Contributions, and Distributions of Profit in an LLC Operating Agreement
The LLC Operating Agreement will have provisions stating what the LLC members have contributed upon the formation of the LLC. Contributions can be in the form of money, property, or services. While not a contribution per se, the Operating Agreement can also provide that the LLC members may have the right to grant loans to the LLC.
The LLC Operating Agreement further has to address the economic ownership rights of its LLC members. (Economic ownership rights are usually distinguished from the voting and management rights of the LLC members.)
There is equity ownership in the LLC which represents the LLC member’s right to share in what is left over of the company upon its dissolution or if it were to be sold as a whole to another person or entity.
Then there is the right to receive distributions of the LLC’s profits as it goes along and makes money. LLC members have a right to receive their share of profits, i.e. money left over from the revenues of the LLC’s business after expenses.
In the most common scenario, LLC members share equity ownership and profit distribution rights equally. For example, if A and B each own 50% of the LLC and nothing else is stated in the Operating Agreement, A and B would each have a right to 50% of the equity ownership and the profit distribution rights.
But it is the beauty of the LLC, that the Operating Agreement can provide otherwise. For example, if A contributed $50,000 to the starting capital of the LLC and B nothing, they could agree that they both own 50% of the equity ownership of the LLC, but that A will initially receive ALL the profit distributions of the LLC until he has received back his initial capital investment.
LLC Member Obligations in an LLC Operating Agreement
These days, LLCs are often founded around a brilliant idea that requires a lot of development, creation, and “sweat equity.” As a consequence, it is a good idea to include certain obligations of the LLC members in the LLC Operating Agreement.
Each member should be obliged to keep all LLC business confidential.
Members should be restricted from competing with the business of the LLC or soliciting employees, vendors, or customers away from the LLC to another business venture. Note though, that restrictive covenants like non-compete provisions and non-solicitation provisions have to be reasonable to be enforceable in court.
If the LLC members are creating intellectual property on behalf of the LLC (software, designs, innovative methods of doing anything), the LLC Operating Agreement must set forth that all such intellectual property has to be immediately assigned to the LLC and is not and will not be the property of the individual LLC members.
Participation in the LLC Business
The LLC Operating Agreement could set forth that certain members have distinct responsibilities with respect to the operation of the LLC. For example, it could provide that A is responsible for research and development and B for sales and marketing. If the agreement was silent, you could potentially have the situation that A works 24 hours a day to make things happen and B sits around and does nothing. Without obligations in the LLC Operating Agreement, A could do nothing about B’s inactivity.
Buy-Sell Provisions in an LLC Operating Agreement
While many LLC Operating Agreements are silent on this point, it is a good idea to include so-called Buy-Sell provisions in the LLC Operating Agreement.
Buy-Sell provisions set forth what is going to happen when an LLC Member wants to leave the LLC, dies, is unable to continue his or her duties, declares bankruptcy, wants to sell his or her interest to an outsider, or when the LLC members are hopelessly deadlocked in the management of the LLC. All of these scenarios could seriously harm the LLC or the remaining members.
The most common buy-sell provision is probably the so-called right of first refusal, which would provide that an owner can sell his LLC membership interest to an outsider if he or she has first offered it to the LLC or the remaining LLC members and such members declined.