Why you should have a lawyer draft your Operating Agreement

You can form a New York LLC online in under 60 seconds.  But you cannot go without an LLC operating agreement drafted or reviewed by a lawyer if more than one member owns the LLC.  LLC operating agreements are quite complex, and it requires special expertise to draft one that leaves you and your fellow LLC members protected.  TEMPLATES FOUND ON THE INTERNET OR PROVIDED BY LLC FORMATION SERVICE COMPANIES SUCH AS LEGALZOOM ARE NOT SUFFICIENT.

Especially if you are or will be a minority member, the templates are very often not in your favor. You may lose out on ever getting any payments from the LLC or being involved in management in any meaningful way.

In a perfect world, each member should have their own lawyer to review the operating agreement. Nobody should contribute money or anything else to an LLC before the operating agreement is properly executed.

Careful if you use a lawyer to draft an operating agreement representing all clients. If clients want me to do that, I will always inform them that this creates a conflict. I cannot be loyal to both members at the same time. By definition, the interests of the members are often not aligned. I can still ethically do it, but I need the client’s informed consent and waiver in writing before I draft an operating agreement.

What is usually included in an Operating Agreement?

The operating agreement 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?

Management Provisions in an LLC Operating Agreement

Management provisions in the LLC Operating Agreement deal with the management of the LLC business, which means decision-making for the LLC. 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 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 Management 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:

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. Decisions that usually require a unanimous vote are the sale of all assets of the LLC, the admission of a new member, the LLC merging with another entity and the amendment of the operating agreement.

Voting Requirements

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.

Confidentiality

Each member should be obliged to keep all LLC business confidential.

Non- Competition

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.

Intellectual Property

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 concerning 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.

Then there could be provisions forcing a buy-out of an LLC member if such member has committed a serious breach of his obligations against the LLC.  Or, in the case of a professional LLC, if any member has lost his license to practice the profession of the LLC. In each buy-out situation, it is important to have terms that provide the exact mechanism of a sale and exit of an LLC member and determine a price for the LLC membership interest.

A buy-sell provision can also determine what happens upon a Member’s death.  If you leave this out of the LLC Operating Agreement, your heirs are most likely at the mercy of the remaining Members. See “What happens when an LLC member dies.”

Limiting the price paid for an LLC membership interest is also common under certain circumstances.  For example, suppose a member decides to leave before the expiration of several years after the company’s formation. In that case, he may not be able to get much, if anything, for his interest since he or she hasn’t put in enough effort to have earned it.

What happens if the LLC has no Operating Agreement?

If there is no operating agreement or if the operating agreement does not cover a topic, the New York Limited Liability Company Law applies. In many cases, this is not good for the LLC members.  The New York LLC and the New York limited liability company law came into existence in 1994.  It was designed as an entity that should be shaped by contract and thus by the members in the operating agreement. The law is designed as a fallback and does not fully protect the members.  Especially minority members are shortchanged by the default rules.  A minority member without an operating agreement protecting its rights may never see distributions of profit, may be frozen out of the LLC by a cash-out merger, or be subject to all kinds of decisions without its consent, including the adoption of an operating agreement not even signed by him or her.  Unfortunately, many new business owners do not heed this advice and still go without a proper operating agreement.  Don’t be that business owner, and do not invest your time and money into an LLC without an operating agreement if you are a minority member.