An operating agreement is a key governing document of a limited liability company (an “LLC”). By its nature, it is an internal, non-public agreement between the members of the company. Ohio law does not require an LLC to have an operating agreement in place; however, having a well drafted operating agreement is highly recommended. While it is widely accepted that big multi-member LLCs need operating agreements, it is often overlooked that smaller companies, including family LLCs and sole member LLCs also need such an agreement in place. Not only is an operating agreement a key document for the members and the company, it’s the document routinely requested by bankers, lenders, and potential investors and an important document for company accountants as well. While Ohio law allows a sole member LLC to have an operating agreement, a declaration of a sole member is a document that is frequently used instead (we will be using the “operating agreement” as a collective definition for both declarations of sole members and operating agreements). Following are the key concepts that make an operating agreement an important document for a business of any type and size.
An operating agreement is a record of its owners and their capital contributions.
Upon filing the Articles of Organization, the Ohio Secretary of State does not require any information with respect to its members. As such, your internal operating agreement is a basic document to keep the roster of the members and their contributions. Some companies go even further and issue membership certificates which are the best evidence of the interest owned in the company. A written operating agreement also helps to establish that an LLC is an entity separate from its owners. This may be crucial for small LLCs where proper recordkeeping helps to shield individual members from a potential personal liability.
An operating agreement spells out the management authority of the company.
One of the key considerations to have an operating agreement is that it addresses who makes the decisions regarding the company, how the decisions are made, and how to resolve a deadlock between its members. This is crucial for a business of any size, whether a sole member LLC, a small family-owned LLC, or a big multi-member LLC. There are multiple ways to manage the business and the owners may develop a structure that works the best for them. The management authority can be reserved to some or all of its members, to the managers, or the board of directors (which is not standard for LLCs). Some decisions of the managers may require the approval of the majority of the members, and some decisions may require the approval of all of the members. Having a clear procedure on how the company is managed and who can make specific decisions helps to avoid potential disputes between the members, very often resulting in extensive and expensive litigation. All decisionmakers should be indemnified by the company for the decisions made and actions taken by them in good faith and within the limits of their authority. Indemnification adds an additional layer of protection for the members’ personal assets.
An operating agreement provides guidance for what happens if one of the members dies or becomes disabled.
Without proper planning, a catastrophic event might seriously influence the overall operation of the business. Very often, the owners do not want the heirs of other member(s) to be actively involved in any management of the business. Therefore, an operating agreement should address what happens if one of the owners dies or becomes disabled. Will the company have a right (or an obligation) to purchase the interest of a deceased or disabled member? Will the company allow the interest to be inherited by the member’s heirs? Who will replace the sole deceased manager and how? There might be additional restrictions for professional companies. Family LLCs can go one step further and appoint a member’s successor in interest pursuant to the provisions of Ohio Revised Code Section 1709, Uniform Transfer-on-Death Security Registration Act, permitting transfer on death registration for any interest.
An operating agreement provides members’ an exit strategy.
An operating agreement can prohibit a transfer of an interest to third parties without the consent of the members (usually, the consent of all of the members). A company may have an option (or even an obligation) to redeem the interest if a member wants to sell to a third party. If members provide services or are personally involved in the business, an operating agreement should address when and on what terms the members can retire. It is crucial to have a predetermined redemption purchase price, a formula or a procedure how a redemption purchase price is determined and how the purchase price is to be paid (i.e., cash at closing or by a promissory note over a certain period). This resolves a lot of disputes between the members, and again, helps to avoid unnecessary litigation. It is also important to protect a company from competition when a key member leaves and an operating agreement should address main restrictive covenants.
An operating agreement addresses financial arrangements between the members.
Profit/loss allocation and cash distribution formulas should be set forth in details. While for asset holding LLCs, it is usually a simple task, it is much more complicated if members generate revenues by the provision of the services or where one of the members devotes a lot of time managing the business. Any profit/loss allocation and cash distribution formulas should be developed in cooperation with a corporate accountant.
A limited liability company provides a lot of flexibility in terms of structuring.
An LLC can have different classes of interests (like non-voting and profit interests). Its members can receive unequal distributions and allocate profit and loss disproportionally to the percentage of the interest owned in the company. This is possible for a “pass-through” entity (i.e., if an LLC is taxed as a partnership or a sole proprietor). However, if an LLC elects an S-corporation or a C-corporation status, the company will be considered a corporation for all tax related purposes. As a result, a lot of the flexibility will be lost, and a lot of restrictions will be imposed on the company
Other key terms that an operating agreement should address.
An operating agreement can require (or prohibit) additional capital contributions. It can provide a “call option,” where members are required to sell their interest to the company. It can provide protection for a founding member in a way that upon any disagreements, the founding member would have the right to keep the business and its location. Alternative dispute resolution terms can be added to avoid litigation between the members, appointing an independent third-party tie breaker or adopting a mediation or arbitration procedure.
It is not possible to develop a “standard” operating agreement and we advise against using an internet form. An operating agreement should be developed by your counsel in cooperation with your accountant. A properly drafted operating agreement can prevent many disagreements between members and provide clear guidance on how to act in certain business situations.
Mansour Gavin’s Business and Corporate Services Group can help you determine the best structure for your business and draft a respective operating agreement. We offer comprehensive legal guidance on all business-related matters that you may face when opening, managing, or selling your business. Contact us today with any questions or concerns.