The Operating Agreement for My LLC: Key Elements and Pitfalls
By far the most common type of new company at the moment is the LLC, the limited liability company. Upon a cursory glance, I couldn’t locate any statistics about exactly how many new LLCs are formed in Pennsylvania and New Jersey each year. Looking at the statistics for Console Matison, LLP (just one small law firm), we report that in 2016 we filed an average of five new limited liability companies per month, the bulk of which represent companies in the City of Philadelphia, with a handful in New Jersey and in the Philly suburban counties.
We start so many small companies as a function of being involved in the ever-expanding Philadelphia real estate market. Real estate entrepreneurial types who buy and sell houses are constantly setting up new LLCs to own those properties. I’ve blogged in the past about this from an asset protection strategy standpoint, and that isn’t what I’m writing about again today.
Today I wanted to focus on a piece of the LLC puzzle that is oftentimes, unwisely, treated as an afterthought: the Operating Agreement. You see, an LLC, unlike a corporation, is formed as a corporate vehicle that is owned, initially, in some percentage proportion, by the founders of the company. Usually you see two folks starting out as 50/50 owners, and figuring their work in forming the company stops there…It doesn’t.
An operating agreement dictates everything there is to dictate about the operation of your LLC (hence the name!). It is the legally binding agreement that the members of the LLC will rely on as a sword to protect their interests and a shield to defend against any attacks. To assume that an LLC does not need a well thought-out operating agreement is to mentally set yourself up for failure, because the first time there is a bump in the road, your company is going to wobble and veer off-course.
Operating agreements, and the value associated with putting time (and yes, $) into writing a good one, function as a way for the members of the company to think through and make decisions on both mundane and key issues regarding their day-to-day and long-term operations. I have seen a (metaphorically) infinite number of clauses and concepts put into operating agreements, but I’ve tried to limit the discussion here to the big ones, the ones that will help you really get your team thinking about building the strongest company you can build:
1. Interests, Profits and Losses: The operating agreement covers the percentage ownership that each member has in the company, what could be more crucial than that?! The reason this is so important is because LLC documents are privately-held. You are not going to publicly record your ownership interest anywhere, the place to get it down on paper is in this operating agreement. You establish two numbers (which are usually the same), the share of the profits entitled to each member, and the share of the losses each member is entitled to take (getting too deep into this concept is fodder for another blog).
2. Members and Managers: Here you establish exactly who has the authority to act on behalf of the company. Does every member have an equal say, or should we establish a ‘manager’ that can handle making certain decisions for us? Establishing managerial roles contains a strategic element for admitting future members into the company, because you are able to establish early on who exactly has any major type of control.
3. New Members: How and when will you admit new members into the Company? Imagine not talking about this, and then suddenly your partner trades 10% of her shares to her friend who then becomes a voting member of the company, and you can’t stop it because you never agreed on the process to admit new members. For shame!
4. Withdrawal or Death: What happens when one member wants to leave the company, or more tragically, what happens if one member dies? Similarly to the discussion above, imagine if your partner died and (after you are done grieving) you find out that her husband inherited all of her shares and is now a controlling member of your company. If you had thought it through beforehand, you could have contracted around this, and created strategies for dealing with things of this nature. Less severely, if a member wanted to leave the company, you would want in place a method for selling their shares: can anyone buy it? How do we value it? Do the other members get first dibs?
5. Dissolution of Company: What circumstances will lead to the company breaking up? How does the breakup process occur? Who owns what? Who is responsible for what?
6. Settling Disputes: This is a big one! Everyone that starts a LLC thinks that getting into business with their best friend is going to be nothing but impassioned brainstorming sessions and company family picnics, with stacks of cash to go around. The reality is that A LOT of new businesses fail, and depending on who you believe that number only ever gets as low as 50%. So chances are there is a possibility you will fail.
Failures start with small disputes, usually about issues related to communication and expectations that each member has of themselves and each other. his is analogous to a marriage, what is assumed and what is left unsaid is often where the cracks in the foundation are revealed (you can tell my wife I have been listening). If you have in place a pre-litigation intervention strategy for dealing with member disputes, you will save time and money and generally create a collaborative instead of adversarial method for resolving conflicts.
There is so much more! That is it for now. As always, if you want to talk LLCs, real estate, or business development for your Pennsylvania or New Jersey business, do not hesitate to reach out to Console Matison LLP, you can find me directly at Joe@ConsoleLegal.com or call me at (267) 603-2493.