An Operating Agreement is a document that memorializes how you and your partners will manage your LLC and provides answers to what you must do in certain situations. These situations may include selling the company, adding a new member or the bankruptcy of one of the partners. An Operating Agreement is important as it will allow you to solve disputes in highly contended situations and will preserve the rules of your partnership. Furthermore, it is a vital part of corporate formalities and will help your limited liability company stand up to judicial scrutiny.
However, an Operating Agreement is useful only if it contains the answers to questions that you and your partners will face in the future.
Here are a couple things that you should consider adding to your Operating Agreement:
- Involuntary withdrawal. This section concerns itself with circumstances in which a member has to involuntarily withdraw from the LLC. It ensures that you do not have to continue to partner with someone who is currently too preoccupied with certain other issues such as bankruptcy or habitual drug abuse. Bankruptcy is often included in the voluntary withdrawal section because, if you need additional capital contributions to keep the business going then the partner who is in bankruptcy proceedings usually cannot provide additional contributions, thereby hindering the company. Furthermore, someone who is habitually using drugs or is mentally incapacitated may not be able to make the best decisions for your company. It is important that you discuss with your partners under which scenarios the partner would be required to withdraw and that you understand why these scenarios would be bad for your business.
- Right of first refusal. This section of the Operating Agreement concerns itself with the sale of the company and whether or not the company or the members have the right to purchase the shares before a third party does so. When you start a company, you are placing a certain amount of trust in your partners and this trust stems from knowing them. When one of the partners wants to leave and sell his shares, he may be selling these shares to party who you do not know, nor trust. If it is present in the Operating Agreement, the right of first refusal provides that before selling the shares to a third party, the partner must offer these shares to the company or the other members. This right ensures that the shares can stay between the members that you already know and trust, thereby not upsetting the status quo. To learn more about buy-sell agreements, check out our blog post here.
- Voting of the members. This section concerns itself with voting and how many members must vote on a particular issue for it to become the rule or the decision. It ensures that the particular vote is a fair and accurate representation of how the members feel. For example, if there are 4 partners in a company, each with a 25% vote, and the decision on the docket is whether the company should be sold, the percentage of members needed to sell the company is extremely important. If only a 51% vote is needed, then one member does not really get a say. If a 100% vote is needed, then all of the members must agree to the sale. The percentage of members needed for a decision can influence greatly how particular decisions are made and who influences those decisions.
- Value of shares. When a member wants to sell her shares, one of the first questions that will be asked is “how much are these shares worth?” The valuation of shares section of the Operating Agreement will provide for a procedure on how to determine the Fair Market Value of shares. This value is often a very contended subject and, having a procedure that is determined beforehand helps navigate through this contention. Whether it is done through looking at the books or by an appraiser, valuation of the shares is important to determine beforehand.
While the above are not all of the things that are included in an Operating Agreement, they are extremely important points that every partnership should consider before going into business together. If you are not sure if your partner is the right one for you, check out our top 10 questions you must ask your partner before starting a business.
Donata Kalnenaite, Esq.