15 min read
Chris Daming, J.D., LL.M.
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When it comes to creating multi-member LLCs, the operating agreement can make or break your company. Often the provisions in an operating agreement, or the lack thereof, can become the basis for lawsuits. Thus, it’s worthwhile to spend some serious time in the early stages of your company ensuring that each of the members of the LLC is on the same page and setting out these decisions in the operating agreement.
This blog is about multi-member LLC operating agreements. We also have another blog that covers single-member operating agreements. Also note -- this blog is an extraordinary deep-dive. So if you're looking for exhaustive information - it's great!
But otherwise, it might be too in-depth for you and you can always use our simplified multi-member operating agreement if that's easier for you.
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If your company doesn’t have an operating agreement, your state’s LLC statute provides standard rules that will apply. Sometimes the gap-filler statute may align with the provision you would have chosen anyway. But more often than not, members probably would have wanted the applicable rules to be different or at least would have appreciated the opportunity to choose which rule was most appropriate for their situation.
For example—let’s say you own 99.9 percent of your company, and someone else owns .1 percent. You want to add an investor to the LLC but your .1 percent owner doesn’t. Unless your operating agreement says you can do it, you’re probably screwed because you’ll need unanimous approval to add another investor. You get the idea—these agreements are important.
This blog will highlight many provisions that LLC members should address in an operating agreement and show the consequences of not addressing those provisions. Drafting a multi-member LLC operating agreement is a complex task, and LLC founders should almost always consult with a lawyer prior to drafting this document.
Of course, there are limits to this rule. If a company has virtually no assets and doesn’t plan to expand, it might not make financial sense to hire a lawyer. But in many cases, LLC members should seek expert advice on multi-member operating agreements.
So why do you actually need a well-drafted operating agreement? When you start your company, the last thing you’re thinking about is a 40-page contract. But your startup will be so much better off once you check the operating agreement off your to-do list. If you don’t, here’s what could happen—your company’s valuation will skyrocket, and all the other owners will suddenly think they should’ve had more rights or more ownership than you believed. It happens all the time.
The name of the LLC, the registered agent, how you define your LLC duration, and the LLC’s purpose are all points that should be discussed in the operating agreement. These issues are also addressed in the Articles of Organization.
Voting is likely the most important aspect to be addressed in an operating agreement. In many states, by default most smaller day-to-day issues can be decided by a simple majority vote. Larger issues, such as whether to admit a new member or to approve a merger with another company, often require unanimous approval among all the members.
You should consider what rules you’d like to apply to voting in the LLC. Every minor issue—like whether the company is paying for lunch—shouldn’t require a vote. If you have one guy calling all the shots (the manager), let that be his call. And all the major issues probably shouldn’t require unanimous approval.
For example, if you have 20 owners and want to sell the company, do you really want to let the guy who owns 1/1000th of the company hold it hostage? Of course not. One method that is appropriate for most LLCs is to select a majority vote for most issues but a supermajority vote for a discrete list of issues, such as an agreement to sell the LLC or its assets to a third party. Very rarely does it make sense to adopt a provision requiring unanimous approval, which can result in a deadlock of the company.
Do you want to allow all your members to transfer or sell their rights? In what circumstances? This provision allows you to limit transfers and sales. As a general rule, most companies allow members to transfer LLC interests but only if the other members agree. The last thing you want is your co-founder Mark giving his new girlfriend Tina ownership in the company because he’s obsessed with her. Why would that be bad? Because that means Tina gets to help manage the company. In this provision, you should state under what circumstances the company can add new members or the members can sell their interests. Also, list the voting percentage required to do so.
Many business owners also don’t recognize the distinction between “financial” and managerial” interests. Understand that you have two different rights when you’re an owner in an LLC. First, you have financial rights, which means you can get money and will get taxed on that money. The financial rights entitle a member to the profits and losses allocations (which include the tax implications) and distributions of money from the LLC. Second, your managerial rights, which is essentially your rights to vote on issues and sometimes to contract on behalf of the LLC. In many states, if you don’t have an operating agreement, then be careful when you “sell” or transfer your interest to someone else. In many cases, if a member tries to sell his or her LLC interest to a third party without unanimous approval from the other members, the buyer of that interest would only be entitled to the financial rights of that membership interest. The consequence for the buyer of that interest is that he or she could not have any right to vote on withdrawing any money from the LLC, but could still be taxed for all the profits of the LLC. As a result, that member may be paying taxes on ghost income for many years after purchasing the interest.
A provision explaining rights to sell to third parties is beneficial because it lets each member “pick-your-partner,” meaning that members will always be able to control who they are operating the LLC with. The operating agreement might have a provision that allows a member to transfer all of his financial rights but the new member would be unable to participate in the management without unanimous approval of the other members. This is also important for potential lawsuit-related reasons. Depending on the state in which the LLC is organized, this provision can potentially prevent creditors from having rights to determine management decisions in the LLC. Imagine that a partner is a 51 percent owner in an LLC that sells clothing. The partner was sued in a lawsuit completely unrelated to the business and has a financially crippling judgment imposed against him. The creditor goes to collect and attempts to recover the partner’s interest in the LLC in satisfaction of the judgment. If the LLC has a pick-your-partner provision, it will prevent the partner from being forced to assign the management rights of his LLC interest to the creditor. So in that case, it helps maintain control of the LLC.
Dissociation means you’ve been partially kicked out of the company (this is different from dissolution, where your LLC ceases to exist). You still get the money and pay taxes, but you can’t vote on any LLC issues. The most common dissociation events are death, resignation, or expulsion of a member. Here’s a tip for these provisions: specify what events are considered dissociation and how it is determined if those events occur. For example, if you want to expel a member, you might require a supermajority vote. If you get that vote, the member would be expelled, which means he would be dissociated.
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You’ve probably heard of buy-sell provisions but aren’t completely familiar with them. In a nutshell, they clarify under what terms people can buy and sell interests in your LLC. Let’s get more specific and start with “puts” and “calls.” A “put” means that you can “put” your interest to the LLC and force it to buy it from you. A “call” means the LLC can “call” your interest and force you to sell it. Your operating agreement should specify when this can happen. An example of when you may want to allow these options is when someone dies, you might let the heir “put” the interest and force the LLC to buy it.
As for calls, if an owner resigns, the other members probably want to call their interest. The last thing you want is to allow a founder to work for three weeks, resign, then sit on his interest while the company skyrockets in value. This makes calculating interest trickier. That’s why you should also include a valuation provision that states how the value of the company is determined. It can be complicated enough to settle on a formula for valuing established businesses. For startups, it becomes even more difficult because many of the revenue-based models applicable to normal businesses don’t apply to startups because of their lack of revenue. However, settling on a method ahead of time helps avoid many problems in the LLC’s future. One of the easiest ways to resolve the problem is to have the LLC decide on a set valuation each year. Then the valuation may be amended each year upon the members’ agreement. The LLC could also agree to have an appraiser determine a valuation; however, this could be a serious expense for the LLC to incur each year and also could create issues in terms of deciding which appraiser to use.
You may also choose to include a right of first refusal provision. If your partner tries to sell his interest for a bargain to his brother, this provision will let you refuse that transaction. If you refuse, however, you have to accept that contract on those terms.
Tag-along rights are useful for owners of a minority interest in an LLC. They typically provide that if a sale of more than 51 percent of the LLC occurs, then the minority owners are entitled to obtain the same sale terms from the purchaser. For example, if an owner of 30 percent of an LLC partnered with someone who owned 70 percent of the LLC and then the 70 percent owner sold his membership to a third party for $700,000, the minority owner would be entitled to sell his interest to the same third party for $300,000.
Drag-along rights are similar to tag-along rights but are useful for majority owners. They allow the majority owner to require the minority owners to agree to sell their interests to the third party if the majority owner desires to sell his interests. Tying this back to the last example, if the 70 percent owner reached a deal with a third party to sell his entire interest, then he could require the 30 percent owner to sell his LLC interest on the same terms.
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You should also include a provision that clarifies the management structure by identifying how’s running the business and what power that person has? Each LLC is typically either manager- or member- managed. Some LLCs have a board of directors or board of managers, but those are rare. It doesn’t make a huge difference whether you choose to be member-managed vs. manager-managed; the real “difference” is what rights that member or manager has. If you want one or a few guys calling the shots, go the manager route. Even then, you can still leave the biggest decisions to a member vote. But if you want all the members to be involved with many decisions, go the member-managed route. Either way, you want to specify who gets to make what decisions.
The company should also determine who has the authority to sign contracts for your LLC. You probably don’t want minority members to have this power. The last thing you want is someone with a 1 percent interest going to a bank and taking out a $100,000 loan for your startup. But at the same time, you probably don’t want your manager signing million dollar contracts without input from other members. To solve this dilemma, give one or a few people the power to sign a contract and bind the LLC. But, say that they can’t sign contracts over a set dollar amount, like ten thousand dollars, without the other members’ approval.
While it may seem obvious, it’s still worth noting that the operating agreement must specify the owners and their shares of ownership in the LLC. Failure to do this can cause serious problems in the future. This point important in the sense that the LLC needs an operating agreement to prove ownership.
Here’s a good example of the worst-case scenario that can result from a failure to have proof of the correct breakdown of ownership percentages. Imagine that an LLC has been operating for two years and is looking to raise capital through investors. The investors will want to see who owns what in the LLC.
Imagine that two years ago, a friend “lent” the LLC $10,000 to help you start the business, and the LLC tries to pay him back around this two-year mark. The friend recognizes that the company is now worth much more money and tries to argue that he had actually given his money in exchange for equity interest in the company.
If investors saw this problem when doing due diligence on the company, they might be wary of investing for fear that in the future the LLC will encounter costly litigation pertaining to ownership percentages. Also, the investors will be afraid that their ownership interests would be diminished in the future when former lenders approach the LLC with proof that they were granted money. A properly drafted operating agreement can resolve all these issues.
Most people have heard of this term “fiduciary duty” but don’t realize that it often applies to them. There are several types of fiduciary duties, including the fiduciary duty of care and loyalty.[cd1] The closest comparison to the duty of care is the concept of negligence. The duty of care is basically a higher level of negligence, which means that to breach the duty of care, a member must be considerably negligent. So, for example, if a member were about to sign a large contract that would bind all of the LLC’s assets to the contract, and the member conducted no research on the vendor, this might result in a breach the duty of care. Here’s a simple way to think about a fiduciary duty: you have to act solely in the LLC’s best interests.
But do you want these duties to apply to the members or to the company? It depends. Many times these duties benefit the company. Of course you want someone running your LLC to be loyal to the LLC. And the last thing you want is for them to steal good business opportunities from the LLC.
To understand why these duties many not always be good: imagine you and two buddies run a three-member LLC that does photography. Your cousin asks you to photograph his wedding on the cheap. And you do it yourself, not through the company.
Arguably, you breached a fiduciary duty of loyalty there. Any time you learn of a business opportunity relevant to the company, you need to give it to the LLC, not yourself. Fiduciary duties can be complex, so here’s my advice: bring this issue to your attorney. Most attorneys don’t customize this provision when they should. So talk to them about it and figure out if it makes sense for you.
LLCs have great flexibility to waive these fiduciary duties if desired. On one hand, it is beneficial to retain fiduciary duties because this keeps all the members loyal to the LLC. On the other hand, it can impose unnecessary burdens and result in litigation in the future. Typically most states will provide that members or managers owe fiduciary duties to each other but can waive other certain fiduciary duties. In Missouri, the law is not clear, but arguably the LLC can waive all the common fiduciary duties because of the freedom-to-contract provision.
As a final note, the LLC can also adopt a provision that provides whether a breach of a fiduciary duty should result in monetary damages or if it should just allow equitable relief—meaning that the LLC could essentially stop or prevent the action that the fiduciary is taking that is considered a breach of his duty.
You also need to specify in your agreement how the company will be taxed. You can choose between partnership, S-Corp, and C-Corp. There are different advantages and disadvantages for each choice, and it’s not worth your time to go into excruciating detail here. But you want to cover it. Check out the tax choice of entity materials for guidance.
Another provision to consider is how the company will decide deadlocks or conflicts among the members? There are many options that will allow the company to address conflicts within the LLC without resorting to costly litigation. First, you can adopt a “Texas shoot-out provision,” which means that if two members are in a conflict, one members proposes terms to sell his or her interest to the other party. If the other party agrees, the first member must sell. If the other party doesn’t agree, the first member must buy their interest at their price. This provision makes members put their money where their mouth is. To mitigate conflicts, you can include some requiring mediation or arbitration. That provision will avoid suits by the members.
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Does the company you have employment agreements with the members? If not, consider adding some of the employment-related terms to the operating agreement. You can add provisions that prevent members from leaving the LLC and then competing against the company. You can prevent the members from disclosing all the LLC’s secrets. Or you can prevent members from trying to steal all the company’s customers or employees if they leave the LLC. Note that the terms of these provisions must be reasonable. If you want more info, review the “employment law” series. The LLC can always execute separate agreements with individuals to cover these issues, or they can be addressed in the operating agreement.
When you take out cash out the LLC, that’s considered a distribution. It's how LLCs distribute profits. Members will be taxed on profits each year, but the LLC must decide whether to actually distribute the profits it made each year.
Let’s say your company makes $100,000 profit one year and you pay taxes on your fair share. That doesn’t necessarily mean you get your portion of those profits right away. Your LLC might prefer to reinvest those profits. This is why you want to address when you can take those distributions.
One provision I like is called the “tax distribution” provision. This requires the LLC to distribute enough money to each member so that he or she can pay the taxes on the LLC’s profits. Otherwise, you could have to pay taxes on profits you’re not even receiving.
To determine what approach to distribution is appropriate for your LLC, the members should consider: Should all profits be reinvested in the business so it continues to grow? Should members take out some or all of the profits so they can have money that you need or want? The LLC can also leave the distributions up to the discretion of the manager, who could decide whether she could use the profits to expand the business or if she thought the profits could be distributed.
Assuming that the LLC doesn’t elect S Corp taxation status, the LLC can have multiple classes of stock. The first important distinction about classes of stock is that an LLC can have something called a “profits interest.”
A profits interest allows the LLC to grant something resembling an ownership interest to a new partner. However, the new partner would only be entitled to the further appreciation of value of the LLC, not to any of the value the LLC is already worth.
For example, if the LLC wanted to give a 10 percent equity interest to someone to manage the LLC, and the company was already worth $10,000,000, the LLC could give the new manager a profits interest. If the LLC were sold on the new manager’s first day, he would not be entitled to any money. However, if the LLC grew in value to $15 million a couple of years later and was then sold, the manager would be entitled to $500,000, which is 10 percent of the difference between the value of the company when sold and value of the company when the manager was granted his profits interest.
Profits interests can also be beneficial for the interest holder because they help him avoid taxation for services. In the previous example, if the new manager were granted a 10 percent interest in an LLC that was worth $10 million and the LLC sold on the first day, the new manager would be responsible for paying taxes on $1 million dollars. This is because he essentially received $1 million for his services. To compare to a more normal set of circumstances, when you work for a large corporation and receive an income of $100,000 for your services, you have to pay taxes on that income. This is the same fact pattern as those circumstances.
The LLC may also create common or preferred LLC interests. Preferred LLC interests typically have some type of preference, whether it be a priority in being paid when the LLC is liquidating or a priority in receiving allocation and distributions. Preferred is a general term that can take several meanings. Preferred can also mean that the interest includes some form of supervotes.
For example, the preferred interest could receive three votes for every one vote that a common interest would receive. One important note: if the LLC chooses to issue preferred LLC interests in allocations, the LLC should consult a tax professional for assistance. The IRS has a stringent set of rules that must be followed. If they aren’t, the IRS will disregard the preferences selected and tax the LLCs members as though the preferences didn’t exist.
In terms of indemnification in LLC agreements, you should state whether the LLC will indemnify the members or managers who are sued as a result of their being a member or a manager of the LLC. This is common and is recommended.
Regarding capital contributions, i.e. Member contributions to the LLC, you should first state how much capital each member is contributing to the company. If a member contributes property, you should determine what the fair market value of the property is and list that as the contribution. The same goes for services.
Less common is a provision called a capital call, in which the LLC can require each member to make an additional contribution after the LLC is formed. This would typically occur if the LLC were running low on capital and needed additional funding to stay afloat.
Also, make sure you address how you amend your operating agreement. This provision absolutely must be included. It’s incredible how quickly amendment becomes an issue. So many startups have had issues emerge almost immediately after organizing and needed to amend based on unforeseen circumstances.
Finally, you should address whether the LLC will have meetings. Corporations, for example, are required to have annual meetings to elect shareholders. LLCs are not required to have these meetings, but you could require them if you desired your LLC to be operated in a more formal manner.
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1 min read
Chris Daming, J.D., LL.M. : Sep. 23, 2024
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