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.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.