A Brief Introduction to the Function of LLC Operating Agreements
The operating agreement is a limited liability company’s (LLC) governing document and the foundational contract among its owners. The operating agreement is the exclusive consensual process for modifying the various statutory default rules pertaining to relationships between the members and between the members and the company. An LLC’s owners are referred to as its “members”. Operating agreements are something of a hybrid partnership/shareholder/buy-sell agreement combined with corporate bylaws.
California’s LLC law is its version of the Revised Uniform Limited Liability Company Act (“Cal RULLCA”). Cal RULLCA governs California LLCs and their operating agreements. The law has been effective since January 1, 2014, with subsequent amendments, and is codified at California Corporations Code sections 17701.01 to 17713.06. Cal RULLCA grants broad, general authority to an operating agreement. Except as otherwise provided in Corporations Code § 17701.10, the operating agreement controls the following matters: (1) relations among the members as members and between the members and the LLC; (2) the rights and duties under Cal RULLCA of a person in the capacity of manager; (3) the activities of the LLC and the conduct of those activities; and (4) the means and conditions for amending the operating agreement. (Corp. Code § 17701.10(a)(1)-(4).)
Cal RULLCA provides default or “gap filler” rules for LLCs. The members can rely on Cal RULLCA’s default provisions to govern their affairs, but this is rarely wise. Operating agreements may, and often should, deviate from many of the default rules. California LLCs are not required to have operating agreements, but it is recommended that they do, even for single member-managed companies. In negotiating the terms of the LLC’s governance, members should consider addressing the following matters, especially at the company’s founding.
Enter into an operating agreement before forming the LLC. Before forming an LLC, consider signing a written operating agreement as soon as practical. Too often, founders rush to form the LLC without having a suitable written operating agreement in place. The operating agreement can state that the members will form an LLC within a certain period or when certain milestones are achieved, and that if those events don’t transpire, then the agreement is terminated. Once you have entered into the agreement, then form the LLC.
Avoid this common mistake in the articles of organization. To form a California LLC, one files a simple document called the Articles of Organization (Form LLC-1) with the California Secretary of State. Section 4 (Management) of the Articles asks who will be managing the LLC. Often, in multi-member LLCs, the company’s organizer(s) will check the box that reads “More than One Manager”, instead of the one that reads “All LLC Member(s)”. The organizer should be sure that this selection is the intended one. A manager-managed LLC is one for which the members intentionally designate or hire one or more internal or external persons or entities to manage the affairs of the company. Sometimes the manager(s) are also members; sometimes they are outside persons without any ownership interest in the LLC. However, if all of the company’s members will be sharing management duties (similar to governance in a general partnership), then the correct box to check is “All LLC Member(s)”.
Eliminate or “bring down” prior representations, agreements, understandings. California law defines an operating agreement as any oral, recorded (written), or implied agreement between the members of an LLC. Corporations Code § 17701.02(s). Unfortunately, as with any contract, oral operating agreements invite disputes among the members and usually complicate resolving disputes in litigation. As noted above, members often form an LLC after having made oral agreements or with certain un-memorialized understandings in place. Problems can arise, however, when the members don’t get around to entering into a written operating agreement, and then decide to abandon the business, dissolve the company, sue each other, etc. In the operating agreement, expressly “bring down” certain prior representations, understandings or agreements between the members, if that is what the parties wish to do, or expressly disaffirm them and start anew with the operating agreement as your binding guide. Generally, a sufficient disaffirmance is found in boilerplate language at the end of an operating agreement. If the draft you have been presented with does not contain such language, it’s probably a good idea to request inclusion.
Sufficiently describe the members’ capital contributions. A person may become a member of an LLC without making or being obligated to make any capital contribution. For those members that will be making contributions, they may consist of any tangible or intangible property or other benefit to the LLC, including money, transfers of ownership or leases of equipment, services already performed, promissory notes, intellectual property, agreements to contribute future money or property, and contracts for services to be performed in the future. A person may become a member without acquiring a transferable membership interest. But if these circumstances are intended, the initial operating agreement or membership interest purchase or option agreement should expressly state so. A schedule to the operating agreement should carefully identify each member’s capital contributions and describe what the manner and value is of each contribution.
Obtain appropriate representations and warranties. Founding members of the LLC should consider requiring each other and future members to provide appropriate “reps and warranties” concerning the following matters:
1. The members’ ability to enter freely into the operating agreement.
2. Rightful and encumbrance-free ownership of the assets being contributed to the LLC.
3. All due and necessary authorizations to enter into the operating agreement and acquire a membership interest in the LLC.
4. Language reflecting applicable federal and state securities law exemptions.
5. Neither admission of the member into the LLC nor the operating agreement itself entitle any member to employment with the LLC or to remain in employment with the LLC, other than as otherwise provided in such member’s employment or other similar agreement with the LLC, if applicable.
Dealing with members who default on obligations to the LLC. If any member owes an obligation to the LLC and fails to satisfy it, there is little the LLC or other members can do short of carrying on with the company’s business or dissolving the LLC. Thus, it is recommended the operating agreement contain a section that gives the non-defaulting members or LLC the right to do one or more of the following:
1. Reduce the percentage membership interest of a member who defaults on making a required capital contribution. The defaulting member’s interest can be increasingly reduced over a period if the default persists.
2. Allow a non-defaulting member to loan the LLC the amount of money a defaulting member failed to pay, and have the LLC repay the loan from distributions that would otherwise go to the defaulting member and/or from the defaulting member’s share of a final distribution on sale of the company. Any loan should be documented and appropriately approved by uninterested members or managers.
3. Grant the LLC an option to purchase the entire membership interest of the defaulting member for its fair market value or a lesser amount.
4. If the LLC declines to purchase the membership interest of the defaulting member, then grant the non-defaulting members an option to purchase the entire membership interest of the defaulting member for its fair market value or less, according to the percentage interests of the non-defaulting members.
Prescribe the particular votes needed to approve important decisions. Operating agreements should stipulate those significant actions and decisions that will require prior approval of members holding a simple majority, super-majority, or unanimity of interests in the LLC. Consider addressing the following list of important subject matter:
1. Additional calls for capital contributions.
2. Admitting a new member and determining the terms and conditions of the admission.
3. Granting non-voting “equity” in the LLC.
4. Appointing officers of the LLC and determining the terms and conditions of their appointment.
5. Signing a contract that obligates the LLC to pay more than a particular amount.
6. Buying, selling, leasing or licensing real estate, equipment, or intellectual property above a specified dollar amount.
7. Acts outside the ordinary course of the activities of the LLC or outside its normal business (“ultra vires” acts).
8. Employment or retention of the services of insiders or family members or friends of insiders.
9. Merging with another entity or converting to a new entity type.
10. Filing for bankruptcy or making an assignment for the benefit of creditors.
11. Dissolving the LLC by a vote of more than 50% of the voting interests of the members.
12. Amendment of the operating agreement.
A written operating agreement may provide to all or certain identified members of a specified class or group of members the right to vote separately or with all or any class or group of members on any matter. Voting may be on a per capita, number, financial interest, class, group, or any other basis. If no voting provision is contained in the articles of organization or written operating agreement, all of the following rules apply:
(a) The members of the LLC shall vote in proportion to their interests in current profits or, in the case of a member who has assigned the member’s entire transferable membership interest in the LLC to a person who has not been admitted as a member, in proportion to the interest in current profits that the assigning member would have, had the assignment not been made,
(b) Any amendment to the articles of organization or operating agreement shall require the unanimous vote of all members, and,
(c) In all other matters in which a vote is required, except as otherwise provided in Corporations Code section 17704.07, voting is sufficient if done by a majority of the members. (Corp. Code, § 17704.07(r).)
Provide for how to resolve voting deadlocks. Members should strive to avoid allowing voting deadlocks to happen. Ideally, the number of voting members or managers is an odd number, and deadlocks can be avoided without having to solicit a vote or resolution outside the company. If this is not possible, the following mechanisms for breaking through a deadlock are usually preferable to the “nuclear” option of dissolution of the LLC:
1. Buy-sell provisions that require the purchase of a dissenting member’s interest in the event of an intractable deadlock. Usually in the form of either:
A. an “appraisal” model that requires one member or member constituency to buy out another member or member constituency. This model uses an independent appraisal by a qualified expert concerning the value of the interest(s) to be purchased;
B. a fixed formula model;
C. a right of first refusal; or,
D. a “shotgun” model, which allows a member(s) to offer to purchase the interest of the other deadlocked member(s) at a set price and terms (usually pursuant to a preset formula or valuation methodology in the operating agreement), and the offeree must then either accept that price and terms, or purchase the offeror’s interest for the same price and terms.
2. External tie-breakers. The deadlocked parties can refer their dispute for decision by a trusted advisor(s) to the LLC, industry experts, or a mediator or arbitrator. The potential downside with this option is that the deadlocked parties would turn over potentially important decision making to an outsider who may not know the LLC’s business and priorities like the members or managers do.
Dispute resolution through mediation and arbitration. This article does not discuss all of the pros and cons of using non-judicial alternative dispute resolution (ADR) for matters concerning the LLC. That said, private, confidential mediation with a neutral experienced retired judge or attorney having experience related to the dispute at issue can be crucial for resolving internal disputes. This often results in a relatively quick and inexpensive means of breaking a deadlock or settling claims by or against the LLC. The members should also consider stipulating that the operating agreement will require all internal disputes be submitted to final, binding, private and confidential arbitration before a neutral arbitrator if mediation fails to achieve a resolution. Arbitration provisions are a sophisticated topic and guidance from an experienced attorney in drafting the provision is recommended.
Provide a method of valuation of the LLC’s assets on dissolution. When an LLC is dissolved, either voluntarily by the members, or involuntarily through judicial action, Cal RULLCA provides default rules for how the company’s property is to be distributed to members. Under Corporations Code Section 17707.05(a), after determining that all the known debts and liabilities of an LLC in the process of winding up, including, debts to members who are creditors of the LLC, have been paid or adequately provided for, the remaining assets must be distributed among the members according to their respective rights and preferences as follows: (a) to members in satisfaction of their due outstanding distributions; (b) to members of the LLC for the return of their capital contributions; and finally, (c) the rest to members according to their percentage interests. The problem with Section 17707.05 is that it does not provide a statutory mechanism for appraising the value of the LLC’s assets on dissolution. A court has the power to appoint someone to wind up the LLC, which includes selling off its assets. The court also has the power to determine the value of the assets or to appoint someone else to do so. But these remedies can be slow to obtain and they may be undesirable, particularly if the LLC’s assets are highly valuable, unique, or numerous. Members should think about including a process in the operating agreement that details who will appraise the value of the LLC’s assets on winding up and the methodology for valuation. The process does not have to be complicated, but including one in the agreement will likely ensure a speedier and more accurate appraisal of assets, which in turn should lead to a quicker disposition of them, and in turn a speedier distribution of the assets or their liquidated value to the members. Note also that if the members want to vary the Section 17707.05 process for asset distribution, the operating agreement or articles of organization must state so.
Consider inserting a non-compete provision. In almost every other circumstance, non-compete provisions or contracts are unenforceable under California law. However, Business and Professions Code section 16602.5 permits a member to agree not to compete “upon or in anticipation of a dissolution of, or the termination of his or her interest in” the LLC. Using non-competes in operating agreements can act to avoid potential litigation should any member terminate his or her interest in the company and then attempt to compete with it.
© 2019, Shanen R. Prout. All rights are reserved.