Most small businesses choose a Limited Liability Company (LLC) as their business form because of the flexibility it allows and the relative ease of setting up such an entity. LLCs provide protection for each owner’s personal assets from the liability and debts of their business. An LLC can be one person or several people. An LLC can be run by its members or by managers not involved in the daily operations of the business. In addition, the profits of an LLC can be passed onto each individual member and taxed on their personal income tax return. Alternatively, LLCs can choose to be taxed as a corporation. In order to take advantage of corporate entity liability limitations, business owners must maintain a clear separation between their personal and business affairs.
Determining who is part of the LLC, how the LLC makes decisions, and how members or managers can be added or leave can be done in a variety of ways. The Operating Agreement is the internal governing document that memorializes how LLC members address these matters. In New York State, LLCs are required to adopt an Operating Agreement within 90 days of the filing of their Articles of Organization (the document filed with the state that created the LLC). The Operating Agreement is essential even in states where it’s not required since most legal trouble happens when there are misunderstandings between business partners concerning the operation of their business. Partners often have misunderstandings about how certain situations will be handled simply because those matters were never addressed, agreed to, and memorialized on the outset of the relationship. The most important issues an LLC Operating Agreement addresses are ownership, management, and transitioning membership either through addition or departure.
The first and most obvious issue having to do with ownership will be determining each member’s ownership interest. Ownership interests are usually determined by the initial investment of each partner. There are other constructs for determining the division of ownership interests. One alternative is to value ongoing services above capital contributions. Ownership interests can affect the voting power of each member as well as the division of profits and losses. An LLC can decide to have voting and profit sharing coincide with the weight of a member’s ownership interest or decide that members should have equal voting strength.
An Operating Agreement can set forth how an LLC will be managed and thus how daily business will be conducted. Most LLCs are member managed, which means that members will make business decisions based on the voting mechanisms laid out in the Operating Agreement. An LLC can also be manager-managed which means that the individuals making the decisions for the LLC may not be members involved in daily tasks, much like how a non-profit corporation is managed by a board of directors. Whether an LLC is member-managed or manager-managed, said LLC can decide whether to appoint officers to carry out specified functions. The Operating Agreement would determine how officers are chosen, for how long, and how they can be removed before an applicable term. The Operating Agreement also lays out the strength of each members vote, which may differ based on their ownership interest or other criteria. Certain matters may require supermajority voting such as adding members or dissolving the company (known as dissolution).
According to the Uniform Partnership Laws of most states, including the New York Partnership Law, any change in ownership calls for the automatic dissolution of a business partnership. However, drafting an Operating Agreement prevents this occurrence by laying out the mechanisms for how members can be added as well as how LLCs continue to function if a member leaves voluntarily or dies. Other situations an Operating Agreement can address include dealing with the removal of a member, the disability of a member, how the shares of a departing member are valued, whether those shares would first be offered to existing members and whether current members could be restricted from entering another business in a related field.
As you can see there are many situations that partners in a business need to discuss and come to an agreement on before those scenarios play out in real life. As many situations that are detailed here, there are many more issues that should be examined with your attorney. An experienced lawyer will have a long list of potential pitfalls to negotiate around and the best solutions for addressing each. When business partners get on the same page it not only results in daily operations running smoother but it also preserves friendships that existed before the business was formed.