Lead Thinking The Business of Software Development

Creating a LLC – Operating Agreement

In my last two posts, I explained corporation types and the initial incorporation.
However, once your company is incorporated, you need to get the members to sign the Operating Agreement.

I’ve “open sourced” our Operating Agreement (links at the end of the article).

The Operating Agreement is a legally binding contract between the members of the LLC. Although many states do not require LLCs to have an Operating Agreement, you should see it as a legal requirement (even if there’s only one member).

An Operating Agreement will give you credibility in court, and it’ll be harder to pierce the corporate veil (i.e. sue you personally) if you’ve got one in place. So essentially you need a Operating Agreement to protect your Limited Liability. It’s also for this reason that if you’re a single member LLC, it’s even more imperative that have a Operating Agreement as it may be that much harder to protect your Limited Liability.

Practically, an Operating Agreement is designed to get all the Members on the same page, and try to prevent disagreements later on down the line. If there are any problems, you and the courts will look to the Operating Agreement for guidance.

Default Rules

Most of the states passed a body of law which aims to codify a common body of laws. These are called the “default rules”.

However, your operating agreement can override the default rules, and it’s a good idea too – even if it’s just for the sake of clarification. Additionally, some of the default rules are definitely not what you want – like equal dividend allocation regardless of ownership in the company.

General Provisions

All Operating Agreements should contain provision that deal with the following topics:

• Governing Law
• Non-compete
• Limited Liability for Members
• Voting power
• Buy-sell provisions
• Dissolution

Membership Interests

A Membership interest is a lot like a share in a normal company – it’s basically a percentage of ownership in the company. Dividends are usually linked to your Membership interest (but again, this can be overridden if necessary).

Depending on your Operating Agreement, certain Membership shares may not carry a voting right – a bit like the non-voting shares issued by some companies. LLCs are flexible, you can give members as few, or as many, responsibilities as you want.

Manager Managed

Manager Managed LLCs give you a bit more flexibility. A lot of businesses have silent partners who aren’t involved in the running of things, and it’s usually preferable to prevent them meddling with your daily operations.

This means you have have two types of membership rights, voting an non-voting. Then you specify that the voting members will have management rights, and the non-voting members no managerial rights.

Appendixes

They should also contain a appendix of Members, their membership share, and the type of contribution they made when joining the company, and its value.

Also, if the company is Manager Managed, you’ll need an appendix of managers.

New Members

It’s important that all new <embers have to sign the agreement. If a Members’ shares are seized by a creditor, then you’ll want to enforce the same rules over the creditor, who’s interests won’t necessarily be aligned with yours.

You’ll also need to decide whether new Members need to be approved by a majority or unanimous vote by the current voting Members.

Transfer of Membership Interest

Your Operating Agreement should contain provisions dealing with how Membership interests get transferred. Most LLCs don’t allow Membership interests to get transferred, by rather assigned. For example, a Member could sell the interest to another party, who would subsequently receive future dividends, but have no voting rights. It would require another vote by the Members to actually make the new party a full voting member. This is another advantage of Manager Managed LLCs and is called ‘charging order protection’ – google it for more information.

Other Provisions

There are a lot of other provisions I haven’t mentioned here – for sake of terseness. These include dissolution, dispute resolution, voting & quorums, management & duties and allocations of profits/losses.

I really recommend Jennifer Reuting’s book, which is much more comprehensive. There is also a good article on findlaw.com about Operating Agreements.

Here is an Operating Agreement you can use as a template:

• Operating Agreement
• Appendix A
• Appendix B

The next post will be on how to get an IRS EIN.