Friday, August 23, 2013

Key Provisions of an Effective Operating Agreement

Every limited liability company should have an operating agreement reflecting the understanding of the parties on how the business should be run.  In part 1 of this series, we examined some real-world business relationships pertaining to operating agreements. In this post, I’ll discuss some important provisions that an effective operating agreement should have to protect the business parties.

Most operating agreements have standard sections, but that doesn't mean that changes can’t be made. An operating agreement should not be viewed as a one-size-fits-all document. Each business is unique and these provisions should be clearly laid out to handle issues as they arise.

Here are some sections and key points that deserve special consideration when a business draws up an operating agreement.

  • Capital and capital contributions — Subsequent contributions should only be an obligation if unanimously agreed upon by all the members.
  • Allocations and distributions — The company should have the right to distribute cash and property to the members pro rata, based on the relative membership interests.
  • Management — The managing member should have the power pursuant to the operating agreement to perform the following on a day-to-day basis: open and manage bank accounts, borrow funds or establish lines of credit up to $5,000, purchase insurance on company assets, enter into agreements with vendors, suppliers, and contractors, and perform other operational tasks and duties.

More substantial actions should require the approval of a majority percentage of the members. These can include: borrowing more than $5,000 or making any capital expenditure in excess of $5,000, commencing lawsuits or other legal proceedings, making a filing under the Bankruptcy Code, purchasing, leasing, or disposing of property—including real property—in excess of $5,000. Lastly, any action to dissolve the company would fall under a majority percentage of member participation as well.

Adding new members to the company (or altering the percentage ownership in the company) should require the unanimous approval by all members.

Withdrawal and transfers of membership interests This should cover such issues as how a member may withdraw from the company prior to the winding down and dissolution of the company, such as if a 60-day prior notice should be given. Also, restrictions on transfer should be clearly laid out, and sale of membership interest details should be given so that adequate time requirements are made known to all members.

A very important provision you always want to include is what would happen in the event of a member’s death, or if a member gets divorced. Washington is a community property state, which means that a spouse has a 50% interest in every single dollar made by a spouse. In every business, a spouse automatically shares a 50% economic interest with the other spouse. So a divorce could significantly impact the business if provisions aren’t made.

I always recommend a clause that says in the event of disillusion of marriage, we’ll recognize that the divorcing spouse has a 50% interest that’s economic only. The divorcing parties agree to put a dollar figure on that interest and the non-member spouse is given 50% monetary value, but not membership in the company, so he or she would not be able to make any decisions pertaining to the business. 

Since each business is unique, your business may require special language to protect all members. If you are considering drafting an operating agreement for your business, contact us to set up a consultation.