What Should go in Your LLC’s Operating Agreement

Limited liability companies in Pennsylvania are organized by filing with the department of state. But the most important document that an LLC’s owners sign is the operating agreement. The operating agreement serves the same function that bylaws serve for a corporation. They are the constitution that governs the organization’s operations. The operating agreement is generally not filed with the department of state, nor with any other government agency. They are an entirely private document between the owners (called members in an LLC).

Operating Agreements are agreements between the LLC’s owners

The operating agreement is an agreement between the members and the organization itself as to how the LLC will be run. It lays out the ownership interest of the parties and provides for dispute resolution. Below are a few things that every LLC operating agreement should consider including:

1. Ownership interest of the members.

The operating agreement is usually the first document to actually name who the owners of an LLC are. Indeed, it is often the only document to name the owners. The operating agreement should identify who the owners are and what their percentage interest is.

There’s a difference between beneficial and legal ownership in LLCs. Someone may have a non-voting interest in the LLC, meaning that they’re entitled to some of the profits of the entity without having any power to determine how the organization is run. Conversely, someone may have a high voting percentage but not necessarily a high ownership interest.

Most LLCs tend to keep it simple, however. If you have four owners, they each have 25%, or if you have two owners, they’re 50/50. But in the case of an even number of owners, what happens if there’s a tie? If the owners for whatever reason are unable to agree on how to run the organization on a very important issue, how do you break the deadlock?

2. Dispute resolution provisions.

For this reason, a good operating agreement should include dispute resolution provisions. These provide that if the members are tied in an important vote, an outside party can be chosen as an arbiter. Sometimes this arbiter is named, but more often, a guide to how the arbiter should be chosen is laid out in case of such deadlock. In extreme cases, operating agreements that we’ve seen at our firm have dictated a coin flip to make a final determination. We certainly don’t recommend that! But even a coin flip is better than nothing in laying out ahead of time how conflict resolution will occur between the members.

Furthermore, having a plan in place sometimes helps everyone avoid such conflict. Knowing that an important vote might be left to a coin flip or an outside arbiter encourages the members to work harder to resolve things before invoking such provisions.

3. Oppressed minority owner provisions.

In cases where there is a majority owner and minority owner, or even where there are a handful of owners, sometimes you want to write in provisions of what happens if one person or more feel like their interests are no longer represented by the whole. As a simple example, if you have six owners and two of them feel that the other four owners are “forcing them out” of major decisions, what rights do these two have?

When LLCs form, the members are usually getting along. But divorces, inter-personal fights, business or artistic disagreements and more can get in the way. If the majority is outvoting the same minority repeatedly, the minority can begin to feel as though their ownership interest is no longer valuable.

Although Pennsylvania law provides a number of avenues for minority owners to address this, its best if you spell out provisions in your operating agreement to govern these situations. Doing so also avoids fights in many cases by giving everyone ways to avoid conflict before it starts, and by spelling out how everyone loses if anyone is being pushed out.

4. Indemnification of officers and members.

Another thing to consider in your operating agreement is having a clear statement about indemnifying officers or members for their work in the company. In the event that an individual is sued for their work with a company, the question often becomes whether the company should have to pay their legal bills. Making sure that your owner members aren’t left to fend for themselves if sued is an important step to maintaining the long-term commitment of all investors to the company.

5. Buyout provisions.

Perhaps the most important part of an operating agreement is a statement about how a member’s interest is bought out once they’ve decided to sell. This happens both when a member sells voluntarily and involuntarily due to bankruptcy or other proceedings. Will the membership interest be appraised? Must it be sold first to other members or to the company? Or can they sell to an outside investor? These and other important questions should be resolved up front before the problem arises. Doing so can avoid costly litigation and unintended consequences of having an unexpected member buy in from the outside without warning.

Conclusion: Speak to a business lawyer about your LLC operating agreement

If you’re forming an LLC in the commonwealth of Pennsylvania, there are advantages to hiring an experienced business lawyer to help you. At Cornerstone Law Firm, our attorneys help draft operating agreements that foresee the types of problems that you may run into even with a single business partner with whom you’re on good terms. A good operating agreement is not a tool to start fights with; rather it can help to prevent conflict down the road.

Call us today to discuss how we can help you in your business.