One of the great things about limited liability companies (LLCs) is the flexibility they provide. Unlike a corporation, you don't need boards of directors, bylaws or annual meetings. You also have a lot more flexibility in the kind of equity you can offer. The management, economic and ownership terms can all be set forth in one agreement, called an "operating agreement" or "LLC agreement."
Because operating agreements are so central for LLCs, it's critical to carefully think through the agreement to make sure it works for your start-up and that you aren't missing anything important. In that vein, we've summarized below the three broad areas that should be addressed in every operating agreement.
If the LLC is "manager managed," the founders should think about what types of decisions should require member approval. These would typically be "fundamental" decisions – like whether to sell the LLC, merge with another entity or shut down and dissolve. Members might also want to approve important decisions like admitting new members, borrowing money (more than a threshold amount) or hiring or firing key employees. Some LLCs have officers; others don't.
The responsibilities and powers of the different actors – members, managers (if any) and officers (if any) should all be clearly set forth in the operating agreement. The operating agreement might also address deadlock resolution, if members disagree.
We generally recommend that the operating agreement include mandatory tax distributions to avoid "phantom income," that is, allocations of taxable income to members who will want the LLC to pay out enough cash to the members so they can pay their income taxes on LLC profits.
You may be able to sell your interest, however. That might create a conflict because the continuing members want to know (and approve) everyone who has an ownership interest. In a start-up or a family business, people will likely be working closely together and they may not want "strangers" participating in the business. For that reason, and because of technical legal issues on limits on transferability, the operating agreement often provides for rights of first refusal. The company and the other members can purchase the interest of a member who wants to sell to an outsider, either for the outsider's price or perhaps for a pre-agreed price.
Operating agreements will often include an exception to the rights of first refusal to allow members to make transfers to family members or for tax planning.
Many start-up LLCs choose to include purchase rights on an "event of dissociation," that is, an event (e.g., death, disability, resignation) that means the member will no longer be participating in the venture. These provisions may give the company and the other members the right to purchase the departing member's shares or perhaps just result in the loss of voting rights by the dissociated member.
The payment terms should also be addressed in the operating agreement. The last thing an LLC wants is an obligation to spend its needed cash to pay out former members rather than invest in the business. The operating agreement may require payment over time, perhaps five or 10 years or more, with the payment obligation secured by pledge of the purchased interest.
Each of these issues requires careful thought among the owners of a new LLC. There are few right or wrong solutions. Candid discussions at the start of the new venture can help avoid misunderstandings or disputes as the business grows.
Day Pitney Partners Stephen Catanzaro, Laurence Smith, and Elizabeth Yoo were featured in New Jersey Law Journal's 2024 New Partners Yearbook, which highlights partners, including lateral partners, made or hired at New Jersey firms.
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The news of Elizabeth Yoo joining Day Pitney as a partner in the firm's Corporate practice was featured in Thomson Reuters' The Daily Docket Industry Moves column. Yoo is based in New Jersey.
Day Pitney New Jersey Partner Elizabeth Yoo’s arrival was featured in the Diverse Lawyers Network newsletter. Yoo is a Corporate Partner.
The arrival of New Jersey-based Corporate Partner Elizabeth Yoo was featured in the Law360 Pulse article "Day Pitney Picks Up Another Chiesa Shahinian Corporate Pro."
The arrival of Corporate Partner Laurence Smith and the promotion of Stephen Catanzaro to Partner was featured in the New Jersey Law Journal's On The Move and After Hours column.
The news of Laurence Smith joining Day Pitney as a partner in the firm's Corporate practice was featured in Thomson Reuters' The Daily Docket Industry Moves column.
The arrival of Corporate Partner Elizabeth Yoo to the firm was featured in the Attorney At Law Magazine article "Day Pitney Further Expands Corporate Practice in New Jersey."
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The arrival of Corporate Partner Laurence Smith to the firm was featured in the Bloomberg Law article, "Day Pitney Recruits Partner to New Jersey Corporate Practice."
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