Do You Need an Operating Agreement If You Are a Member of an LLC? YES!

You and your business partners just purchased an apartment building through an LLC. Everyone is excited and optimistic about the new business venture. Filled with this excitement and optimism, the partners overlook signing an Operating Agreement. That oversight has consequences that may be avoided if an Operating Agreement is signed. Here’s why.

• What is an Operating Agreement? An Operating Agreement sets out the rules that govern how the LLC’s business is conducted. These rules affect each member’s relationship with the LLC and each other by outlining the rights and obligations of the LLC and the members. Perhaps most importantly, the Operating Agreement defines the powers and duties of the members and how they are compensated.

What terms are included in an Operating Agreement?

• Who is running the company? The day-to-day operations of an LLC are carried out either by its members or its managers. In a member-managed LLC, the owners, that is the members, conduct the business of the company while in a manager-managed LLC, the managers who are selected by the members conduct the business of the company. Smaller LLCs are generally managed by members and larger LLCs are generally managed by managers. Without an Operating Agreement in place, the law of the state where the LLC is formed and not the members decides how the LLC is run.
• What happens if members cannot agree on what to do? When the members of an LLC cannot agree on what the company should do–for example–borrow money, a deadlock exists making the company unable to conduct business on that point. An Operating Agreement sets forth how deadlocks will be broken. For example, the Operating Agreement can designate an individual who will cast a tie breaking vote or the Operating Agreement can establish a procedure like mediation to arrive at a consensus to break the deadlock. Without an Operating Agreement, the law of the state where the LLC was formed and not the members decides how deadlocks will be broken.
• Who gets paid what? An Operating Agreement specifies what each member has contributed to the LLC and how the members get compensated. Contributions by members can be money, skills, labor, or other items of value. Based on these contributions, the members own proportionate interests in the LLC and compensation may be based on the proportionate interests or some other formula set forth in the Operating Agreement. Without an Operating Agreement, the law of the state where the LLC was formed and not the members decides who gets paid what.
• To whom may I transfer my interest in the LLC? The Operating Agreement provides the procedure for transferring an interest in the company. The procedure may require unanimous consent by other members or some other percentage in favor of the transfer. Rights of first refusal in favor of the current members to acquire the interest of a selling member may also be contained in the Operating Agreement. The Operating Agreement sets forth payment terms and how the sale will be effectuated. Without an Operating Agreement, the law of the state where the LLC was formed and not the members decides transfer and payment rights.

Members should control their rights and obligations to their LLC. Entering into a new business venture is the important work of the entrepreneur. In recognition of the importance of that work, it is prudent, in fact practically indispensable, for the members to enter into an Operating Agreement. The Operating Agreement permits the members and not the law of the state of formation to control the operation of the LLC and thus the destiny of the business venture.

If you are contemplating forming an LLC, Maggs McDermott & DiCicco can help you navigate the path to define the rights and obligations of the company and its members. Please contact us at [email protected] or 732-655-8339 for a free consultation.