Checklist for Drafting an LLC Operating Agreement
by James E. Robinson, Esq.
When it comes time to prepare the operating agreement for a New York limited liability company (“LLC”), the company’s owners (the “members”) should consider the following issues:
- What will the respective ownership interests of the various members be?
- Is ownership to be expressed as a simple percentage or will certificates for “units” (similar to shares of stock in a corporation) be issued to members?
- What vote or approval will be required for the admission of new members?
- What will the respective capital contributions of the members be? Will such contributions consist of money, services and/or be in some other form?
- Will profits and losses be allocated among members in proportion to their ownership interests/number of units owned or in some other manner?
- Will the LLC be managed by its members (structure similar to a partnership in which all partners generally vote) or by managers (structure similar to a corporation in which directors are elected)?
- If management is to be by managers, how many managers will there be? Will they be elected periodically by the members or will certain people be designated in the agreement to act as managers indefinitely (or for some other term)?
- Regardless of whether management is by the members or by managers, what vote will be required in order for the company to take action on a matter (e.g. a majority, two thirds, unanimous approval)? In the case of voting by the members, will each member have a vote that is proportional to his or her ownership interest, or will it be one person, one vote?
- It’s not uncommon to set a greater voting requirement for certain matters affecting the structure or existence of the LLC itself, e.g. dissolution of the company or approval of the sale of all or substantially all of the company’s assets – should there be such a greater voting requirement?
- Will the LLC have “officers” similar to those in a corporation? If so, what will the offices be (e.g. president, COO, CFO, secretary, treasurer, etc.) and what powers and responsibilities will the holder of each office have? How will people be appointed to fill the positions – by vote of the members or managers, by designation in the agreement? For how long will the office holders serve – e.g. one year, indefinitely, etc.
- Do the members wish to designate a specific bank where the LLC’s accounts will be maintained and/or specify which/how many members will be required to sign checks?
- What will the LLC’s fiscal year be? Where will its books and records be kept? Which member will have primary responsibility for tax issues and be designated as the “tax matters member”?
- Are there to be restrictions on a member’s right to sell his or her interest in the LLC? A common requirement is that a member wishing to sell his or her interest first offer it to the company or the other members for purchase, sometimes at a reduced price such as book value.
- What will happen upon the death of a member? Often, the LLC or remaining members will want the right to purchase the interest of the deceased member so as to be able to retain control of the company. If provision is to be made for a buy-out of the deceased member’s interest, will life insurance be purchased to fund the buy-out?
- What will happen upon the disability of a member? Here there are usually two considerations. First, will a member who becomes temporarily disabled be entitled to continue to receive salary/compensation (or partial salary/compensation) for some time period? Second, if a member becomes permanently disabled, or if a disability continues for some extended period – say, a year – will the interest of the disabled member be bought out by the LLC or the other members? Will disability income insurance and/or disability buy-out insurance be purchased to cover these contingencies?
- What will happen upon the retirement of a member? Here again, a buy-out is often provided for as it allows the remaining members to retain control of the LLC and provides the departing member with a source of funds for retirement or other endeavors. Is there to be a minimum age (e.g. 65) which must be attained before a member may retire and “cash out” (or will there be a reduction in the amount of the purchase price for a member’s interest depending on how early he or she retires)?
- In the event that a member’s interest is to be bought out, how will the value of that interest be determined? There are any number of approaches, including: (i) agreeing on a number and providing for that number to be updated from time to time (this approach being the simplest and most cost-effective, but subject to the reality that in many cases the members neglect or forget to update the number); (ii) agreeing on the use of a formula (e.g. a multiple of earnings) or the average of the values yielded by multiple formulas; or (iii) agreeing to obtain a formal appraisal of the value of the business at the time of the buy-out (this being the most expensive approach, but generally the most accurate).
- Another issue concerning buy-outs is whether the interest of a departing member will be purchased by the LLC (a “redemption”) or by the other members (a “cross-purchase” – often made by the remaining members in proportion to their respective interests in the company)? There may be tax benefits/costs associated with one method versus the other and thus the company’s accountant should be consulted on this question.
- Are there to be any restrictions on the right of a departed member to engage in a similar practice or business? Such restrictive covenants can incorporate, among other things, a time component (e.g. the restriction will be in effect for one year after a member leaves the company); a geographic component (e.g. the former member cannot operate a like business within a 5-mile radius of any office of the company) and/or a client-based component (e.g. the departed member will be prohibited from soliciting or accepting work from existing or identified prospective clients of the company).
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Please note that this article is intended only as a general discussion of issues which may be confronted by the members of a limited liability company in drafting an operating agreement and that it should not be taken as creating an attorney-client relationship or as legal advice with respect to any particular person, business or situation. Circumstances and the applicable legal principles vary and you should consult with an attorney before entering into any contract or agreement.