OPERATING AGREEMENT PROVISIONS
What goes into an LLC Operating Agreement?
An Operating Agreement is the constitution of an LLC. It is an agreement between the founders and other “members” (a.k.a. owners) establishing ownership, power, financial rules, and other important provisions. Below is a summary of some of the most important provisions you may find in an LLC Operating Agreement.
OWNERSHIP & POWER
An Operating Agreement will establish who owns what percent of the company and what type of ownership each member has.
1. Membership Units
An LLC is generally divided into “membership units” — which is basically the equivalent of stock for a Limited Liability Company. You can choose how many membership units your LLC is comprised of (i.e. how many pieces the 100% ownership is divided into). Here, its common to pick a high number to allow yourself greater flexibility when allocating ownership percentages. For example, 10 million membership units is common, in which case each unit is worth .00001% of the company.
2. Types of Membership & Management
With an LLC you can have different classes of ownership with different rules and rights that apply to each. This allows you to have some owners who are in charge of running the business and making company decisions, and other owners who do not have a vote in most company decisions. For example, its common to have:
A. “Voting Units” given to “Voting Members” or “Managers”
- Often given to the founding members of the company, or other individuals designated to run and manage the company proportionate to their assigned voting interest.
B. “Non-Voting Units” given to “Non-Voting Members.”
- Often given to investors, employees, or other owners who will not vote in the day-to-day operations of the company.
- Still entitled to participate in profit distributions proportionate to their ownership percentage.
- Generally able to vote on certain important company decisions, such as selling or dissolving the company.
C. Other Classes of Ownership
- For more complex business structures, you could also implement rules for other classes of ownership (i.e. Class C Units, Class D Units, etc.) and you could assign different rules for each as needed by the company. Each class might have rights to vote on different types of company decisions and could be subject to different rights to profit distributions.
3. LLC Officers
The company may also designate officers who are in charge of running certain day-to-day operations. Common officers include the Chief Executive Officer, Chief Financial Officer, and Secretary. These officers are generally appointed and managed by the company's management.
It is also common to have founders and employees earn ("vest") their ownership percentage over time — especially when a founder or employee’s ownership is stipulated on their active involvement in running or servicing the company. This way, if such a member stops working for the company prematurely, the remaining members won’t be forced to buy them out for their full ownership percent because they will not have earned it yet.
Four Year Vesting with One Year Cliff
For example, a common vesting scheme is to have a member earn 25% of their allocated membership units after one year, and the remaining 75% of their ownership earned in equal monthly increments over the next three years. This way, if they quit or are terminated in the first year (before the cliff), they will not have earned any equity and don't need to be bought out. If they quit or are terminated anytime thereafter, they may only need to be bought out for the percentage of ownership they have earned. Any unvested equity is generally forfeited back to the company at the time a vesting member quits or is terminated.
RESTRICTIONS ON TRANSFERS OF INTEREST
This provision restricts how members may sell their membership units. For example, you may not want your co-founder to sell their interest to their cousin and then suddenly find yourself with a new business partner co-running your business.
No Transfers without Permission — Some LLCs simply forbid any transfers of interest without the permission of the management. This protects the LLC, but limits the value of one’s ownership as their is no guarantee the LLC will ever let them sell their units to the outside market.
Right of First Refusal — Alternatively, it is common to grant the company the “right of first refusal.” Here, a member can only sell their interest outside the company after they have first offered to sell the interest back to the company for the same purchase price offered to them by the potential buyer.
If the company chooses not to buy the interest from the member for the offered purchase price, then the member may sell the interest to the outside buyer — who will generally become an “assignee” of the interest without any rights to be involved in the operations or management of the company.
FINANCES & PROFIT DISTRIBUTIONS
The Operating Agreement will cover company finances, including when and how profits are distributed to the members.
Flexible — Often, the Operating Agreement will simply say that profits may be distributed at any time as determined by the management. This is flexible and allows the company to make distributions as it chooses.
Guaranteed — In other instances, members might prefer to have some guarantees. For example you could set certain mile stones where profit distributions must be made when the company reaches designated financial benchmarks. This can help protect members who may not have managing control over the company but want to ensure profit distributions are made at certain times.
DRAG ALONG & TAG ALONG RIGHTS
Some Operating Agreements include rights that help unify the members in the event of the sale of the company. These rights prevent minority dissenting members from stopping the sale of the company and also grant minority members the rights to be included in the sale of the company.
- Drag Along Rights — Allows members holding a majority interest in the company to force minority interest holders to sell their interest to a buyer in the event of the potential sale of the company.
- Tag Along — Grants minority interest holders a right to be bought out for same terms and conditions as the majority holders in the event of the potential sale of the company.
OTHER COMMON PROVISIONS
- Meetings & Voting — Designates when meetings of the management / members will take place and how voting may occur. Often permits some actions to be taken by written consent of the majority voting interest without having to call a formal meeting.
- Capital Accounts — Each member will generally keep a “capital account” tracking cash or resources contributed by the member toward the LLC.
- Books & Records — Requires the company to keep books and records and grants members rights to access them.
- Limitations on Liability and Indemnification — Limits the personal liability of the management for company decisions, and may guarantee the company will protect the managers in the event of legal disputes.
- Tax Provisions — Proscribes tax codes the LLC may utilize or must abide by.
- Dissolution — Details how the company may be dissolved. Generally requires the company to first pay off any debts, and then allows any remaining assets to be divided amongst the owners.