Starting a business with partners can be fun, but complicated. Many entrepreneurs even recruit their family and friends as co-founders to get things off the ground. They tend to believe mob boss Michael Corleone’s assertion that “It’s not personal, it’s strictly business”. I disagree. Business can become deeply personal, especially when there are disputes or close relationships at stake. That’s why it is critical to lay out some rules of the road prior to beginning a new venture with other people. If your company is organized as an LLC, then creating an operating agreement is an effective way to accomplish this. In this article, I discuss the basic provisions in operating agreements. Please keep in mind that this is an overview. You should always seek legal counsel when drafting an operating agreement for your business.
What is an Operating Agreement?
The Michigan Limited Liability Company Act (LLCA) defines an operating agreement as a “written agreement between all the members of an LLC that pertains to the affairs of the company and the conduct of its business”. You don’t need an operating agreement to start a business in Michigan, but they’re still incredibly useful. To expand on the LLCA’s statutory definition, I believe an operating agreement has two objectives. It explains how a business operates and how the people in a business relate to each other. Let’s take a closer look at how these objectives work in practice by exploring some basic operating agreement provisions.
Identifying the Members
An operating agreement should identify the parties and their ownership interests. The parties or owners in an LLC are called members. Both individuals and legal entities can become members. An operating agreement typically lists the members’ identifying information, including but not limited to, names, addresses, emails, and telephone numbers to make company communications more streamlined. The members make initial capital (money or property) contributions to the LLC in exchange for ownership in the company, otherwise referred to as a membership interest. Membership interests carry specific voting and economic rights in the business. Please keep in mind that there are exceptions to these rules. For example, a party may become a member of an LLC without contributing capital or a membership interest may only carry economic rights. These scenarios and others are beyond the scope of this article and require an attorney to evaluate the specific circumstances. Operating agreements also may have capitalization tables, which identify the member, their voting percentage (if any), their economic ownership percentage, and their initial capital contributions.
An operating agreement should define how the LLC is managed. LLCs are generally either member-managed or manager-managed. In a member-managed LLC, the members collectively make all company decisions. In a manager-managed LLC, the members elect a professional manager or one of the other members to make company decisions. There are also scenarios where the LLCs are a hybrid of both management structures. For example, in a manager-managed LLC, the manager might make day-to-day operations decisions, while the members make significant decisions like selling the company or admitting a new member. The operating agreement can also include decision making procedures. Examples of these procedures are meeting & voting processes, the standard of care for decision making, compensation for management activities, how the LLC transacts with other individuals or entities, and liability for decision making.
Contributions, Distributions, and Allocations
An operating agreement should identify procedures for how capital (money or property) comes in and out of the company. In addition to receiving their membership interest, a member’s initial capital contribution creates their capital account. As the business progresses, the company may request additional capital contributions from the members or make capital distributions to the members. The member’s capital account is generally adjusted to reflect these capital contributions or distributions. Adjustments to a member’s capital account can also affect that member’s allocation of the profits and losses of the LLC. If a member does not make capital contributions in a timely manner, the operating agreement can determine how it affects their rights to capital distributions or their allocation of profits and losses.
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