Single member limited liability companies are easy – It’s just you making all the decisions. When you start a company with others, there has to be a meeting of the minds on how decisions will be made, and a well-drafted operating agreement is essential to building your business on a strong legal foundation. The operating agreement serves as the rule book of a company. Its contents can vary widely because of the flexible nature of LLCs. However, there are certain terms which should be contained in every operating agreement so that the members of the LLC have a clear understanding and agreement on how their interests will be treated and how the business will be run.
One of the most important functions of an operating agreement is to authorize the number and classes of ownership units that the company may issue to its members. If there is more than one class of units, the operating agreement will outline the different voting and distribution rights of each class. At Stock Legal, our multi-member LLC operating agreements including capital voting units, capital non-voting units, and profits interest units. Capital units are owned by founders and sold to investors. Profits interest units are incentive units granted to employees and services providers, and have different distribution rights than capital units (more to come on profits interests in a later blog).
The operating agreement should also define how the co-founders will run the business. LLCs can elect to be managed by its members, a managing member or by a board of managers. In either case, the operating agreement needs to set forth the different levels of approval that are required for the company to make decisions. For example, in a board managed LLC, the operating agreement will set forth what decisions the board can make (without obtaining the approval of the members), but will also set forth certain decisions that are important enough that they require the members’ approval. Again, because of the flexible nature of LLCs, this can be set up any number of ways depending on, among other things, the number of members, how involved they want to be in running the company and the company’s plan for growth.
An operating agreement should also establish when and how ownership units can be sold by the company and by the members. For example, we recommend including pre-emptive rights and a right of first refusal in an operating agreement. Pre-emptive rights are triggered when the company wants to issue units in a capital raise. If the existing members have pre-emptive rights, it means that before the company can issue units to a third party, the existing members have the opportunity to purchase their pro-rata share of the units being offered so that their ownership percentages are not diluted. Similarly, the right of first refusal is triggered when an existing member wants to sell his or her units in the company to a third party. With the right of first refusal, before a member can sell his or her units to a third party, the selling member is first required to offer to sell the units to the other existing members.
Tag-along and drag-along rights are also important provisions to include in an operating agreement, especially if the company intends to raise capital in the future (because investors will be looking for these provisions). Tag-along rights protect the members who have a minority stake in the company in the event a majority of the members decide to sell their units to a third party by allowing them to “tag along” in the sale. Alternatively, Drag-Along rights allow a majority of the members to “drag” the minority members into a sale. This protects the members that have a majority stake in the company by helping ensure that the price is right, because selling 100% of a company is often worth more than selling less than 100%.
The operating agreement should also contain a schedule, called a capitalization table (or short-hand, a cap table), which is attached at the end of the document, which shows the members of the company, the number of units they own, and their percentage of ownership interest. This is an essential part of the operating agreement - because most LLCs do not use unit certificates, this schedule is the only record of ownership of the company.
At Stock Legal, we offer operating agreements for a fixed fee. Our clients love this option because they don’t have to worry about how many hours they are racking up with each turn of the document or be worried about a surprise giant legal bill. They know up front what it will cost to get their company on a solid foundation with a well drafted operating agreement crafted to their needs.