LLC Operating Agreement: Every LLC Needs One

The first question I ask small business owners is whether they have an operating agreement. Second, I ask whether they are following it. If you are a member of a LLC, please ask yourself these questions:

  • Do you have a written operating agreement?
  • Where is it? When was the last time you reviewed it?
  • When was it amended?
  • Member Ownership: Does it clearly state how much each member owns?
  • Voting and Major Decisions: Does it clearly state how much voting power each member has, particularly regarding major business decisions?
  • Distributions: Are members paid according to the operating agreement?
  • Wind Up: Does it explain how and when members can close the LLC?
  • Transfer of Ownership: Does it explain how a member can leave or be removed?
  • Protecting Assets: Is your company doing what it needs to do to maintain limited liability?

If your LLC does not have a written operating agreement, you are playing with fire. Oral operating agreements are next-to-impossible to enforce in Wisconsin. Failure to have a written operating agreement invites uncertainty and litigation. I am very impressed if you are a member of an LLC and know the answers to all these questions. You are crushing it. If you do not know or if you have questions, this post is for you.

In Season 1, Ronald and Nick should have forced Izzy to add them as members of GenCoin. They should have had a major decisions clause that forced Izzy to obtain a majority vote before selling the company to Alex Bell or otherwise adding members to the LLC. I am only on Season 2 right now, not sure what happens with ArakNet…

Customize Your LLC and Plan Ahead

Wisconsin LLC laws allow LLC operating agreements to be extensively customized to fit member needs. Almost every Wisconsin statute dealing with LLCs allow for LLC laws to be modified in an operating agreement. The few limitations on this contract require members to deal fairly with the LLC when there is a conflict of interest, and forbids members to derive improper personal benefits.

Operating agreements allow for members to plan ahead and avoid some of the most obvious business-killing disputes. Members benefit from removing any ambiguity regarding ownership interest. Multi-member LLCs need to clearly define how major decisions will be handled and who has voting power. Almost all LLCs will eventually dissolve or merge, and prudent LLC owners will plan for how and when this can occur. LLCs will likely find that one or more members want to leave (or be removed). Defining the rules for transfer of ownership and valuing the business can help decrease exposure.

Operating agreements further help business owners achieve their ultimate goal – protecting their ass(ets). Ignoring corporate formalities is a sure-fire way to lose the primary purpose of operating a LLC, the limited liability. From a litigation perspective, it is incredibly difficult to resolve disputes quickly and effectively between members without one. LLCs are challenging to manage and often fail because they don’t have one, even if the business is successful.

LLC Operating Agreements and Member Ownership Clause

Members typically provide cash, property, or services. Members can be individuals or businesses. All members need to know how much of the LLC they own, which is likely based on their contributions. This can sometimes be accomplished in one sentence. However, customized provisions can allow members to negotiate differing ownership rights based on the length and success of the business. These are common when a member primarily provides capital, and another provides talent. The capital member may want more ownership initially to recoup the investment. That member may also recognize that the long-term health of the company dictates that the talent vests more ownership over time (and success).

LLC Operating Agreements and Voting and Major Decision Clause

Prudent LLC members, particularly members of multi-member LLCs with differing percentages of ownership, will clearly define how major decisions are resolved. The two most popular voting provisions are 1) each member gets one vote, and 2) each member’s voting power is dictated by the percentage ownership.  The default provision is each member’s voting power is dictated by the percentage ownership. This is not ideal for a minority member in a two-member LLC, and in many other scenarios.

Major decisions should require greater authorization, and in turn greater time and consideration, than day-to-day operating decisions. These decisions may include amending the operating agreement, authorizing a manager, admitting or dissociating members, mergers and acquisitions, hire and fire of vital employees, and winding up. Careful consideration should be given to who can make these decisions and by what majority – i.e. majority, supermajority, or unanimous.

LLC Operating Agreements and Distributions Clause

Allocation of profits, losses, and distributions are determined by the default voting provisions outlined above when there is no operating agreement. Minority owners of multi-member LLCs need to be cautious regarding distribution provisions. They may not have enough voting power to timely reap the benefits of a successful business.

LLC Operating Agreements and Wind Up Clause

If an operating agreement does not provide otherwise, Wisconsin law requires written consent of all members for an LLC to be dissolved. If there is no consent, it is likely that one or more members will explore a voluntary dissociation. Wisconsin law provides that the dissociating member is entitled to receive a distribution “in complete redemption of the fair value of the member’s interest in the LLC.” For small companies with only a couple members, the financial impact could cause the company to fail anyways. It is vital that members consider the impact of untimely requests to dissociate, and attempt to shield the LLC from negative impacts.

LLC Operating Agreements and Transfer of Ownership Clause

As discussed above, Wisconsin law allows for a member to voluntarily leave at any time and demand fair compensation for their ownership interest. Valuing a small business can be very challenging, and litigation costs surrounding valuation could drive the company into the ground. If a member makes this demand at an inconvenient time, the company could miss out on important business opportunities.

An LLC’s value may hinge on those members staying in the LLC. It may not be helpful to the LLC to simply replace the member – the departing member’s talents or connections might be underpinning the success of the entire company. Wisconsin’s standard rules could be used offensively absent a thoughtful operating agreement.

LLC Operating Agreements and Protecting Your Ass(ets)

A primary goal of an LLC is often to protect the personal assets of the members. They want to start and transact business, but they do not want to go broke and put their personal assets on the line. Personal liability for business exposures can wreck personal finances and family relationships. I know of multiple LLC litigants whose personal liability led to broken familial relationships or other personal hardship.

It does not have to be this way. An operating agreement can help members of an LLC keep their personal exposures limited. The best way to lose limited liability is to ignore rules set out in the LLC operating agreement and operate the business like a personal bank account. Commingling of personal assets and expenses is often cited when courts pierce the LLC veil and allow for claims to be brought against the members in their personal capacity. An operating agreement can put helpful guardrails in place to avoid personal liability.

Litigating Multi-member LLC Disputes

Litigation between LLC members can get expensive. An operating agreement will likely help limit the number of outstanding questions to fight about. They are customizable and help business owners plan for many of the most common disputes. Good fences make good neighbors – including between members of your LLC.

I am happy to help small business owners draft, amend, or enforce their operating agreements. The above is simply an overview of some of the most common operating agreement provisions. It is not legal advice and should not be supplanted for the advice of an attorney. If you were unable to answer the questions posed in the intro, or have any questions about the above, feel free to contact me to discuss.

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