Why Your LLC Needs an Operating Agreement

| Corporate Law

By:  Ryan D. Krumrie, Attorney at Hager, Dewick & Zuengler, S.C.

The most widely used entity to operate a small to medium-sized business is the limited liability company (“LLC”).  An Operating Agreement is likely one of the most important documents your business will utilize.  Given that each business is unique, a carefully tailored Operating Agreement, as opposed to a pre-printed form or something found on the internet, is preferred and far more beneficial to your LLC.  This article will summarize the major reasons why your LLC needs an Operating Agreement.

Restriction on Transfer.  One of the most significant benefits of an Operating Agreement is creating a restriction on the transfer of each member’s units.  Without a restriction on transfer clause in an Operating Agreement, the members of the LLC can freely transfer their membership units to any third parties and, in practice, obligate you and the other members of the LLC to have new business partners.  A restriction on transfer clause can prohibit this action by allowing the LLC, or the other members, to purchase the units that a member is attempting to sell to a third party at a predetermined price.  Finally, the Operating Agreement can set forth certain permitted transferees to allow the members of the LLC to freely transfer his or her units to another member, his or her spouse or children, or any other third parties the members agree on.

Triggering Events.  Many business owners neglect to think about what will happen if one of the members of the LLC were to die, become disabled, file bankruptcy, retire or voluntarily withdraw from the LLC.  All of these triggering events can be detailed in the Operating Agreement so its members understand what will happen if one of these unforeseen events were to take place.  In the event of death or disability, the LLC or its members can either be given an option to purchase or be obligated to purchase the deceased or disabled member’s units.  If the members of the LLC are also employees, detailed provisions can be included with regard to what occurs if a member is terminated voluntarily, for cause or retires.  Finally, the Operating Agreement can provide the LLC with rights to purchase the member’s units if he or she files bankruptcy or voluntarily withdraws from the LLC, sometimes at a discounted purchase price.

Decision Making.  Whether an LLC is managed by its members or a manager appointed by the members, the Operating Agreement can detail the scope of decision-making authority.  Some LLC’s may choose to give the managing member or manager broad authority to run the day-to-day operations of the LLC, execute contracts, pay vendors, etc. and only require a vote by the remaining members for very important decisions such as obligating the LLC to loans, sale of certain business assets, etc.  Alternatively, some LLC’s will want more than one member involved in the day-to-day decision making and can set certain limits as to the authority of the managing member on behalf of the LLC.

Buyout Price.  Another advantage of an Operating Agreement is its ability to set forth a mechanism for the valuation of the LLC and establish a buyout price if any triggering events occur.  Many times, an LLC and its members choose to set the value of the LLC on an annual basis.  Another option is to have a predetermined mechanism for the valuation of the LLC. This value may be based on the book value as established by the LLC’s accountant or by a fair market appraisal by an appraiser familiar with the business.  Regardless of the valuation method selected, avoiding further disputes as to how the LLC will be valued and determining the buyout price is another benefit of the Operating Agreement.

Noncompetition, Nonsolicitation, Nondisclosure.  An Operating Agreement can also prohibit a member who leaves the LLC from certain acts.  First, the Agreement can contain a noncompete clause prohibiting an exiting member from competing with the LLC’s business, subject to detailed restrictions.  Second, the Operating Agreement can prohibit an exiting member from soliciting customers or employees from the LLC for a certain period of time.  Finally, the Operating Agreement can contain a nondisclosure or confidentiality clause prohibiting the member from disclosing any confidential information to third parties.

These are only a sampling of the various reasons why your LLC should have an Operating Agreement.  By entering into an Operating Agreement, the members can decide what terms and conditions work best for the LLC, rather than depending on litigation to resolve problems at a later date.  While having an Operating Agreement drafted by a qualified attorney may take some time and expense, it will certainly be worth it in the future where an unforeseen event or issue arises.  In addition, knowing that the Operating Agreement is in place will allow the members to do what they need to do – operate the business profitably.