Mar 08, 2018

Crafting a functional operating agreement for your business

The most popular and prevalent form of business today is the limited liability company (LLC). LLCs are user-friendly and provide many benefits such as:

  • the limited liability protection of a corporation;
  • flow through taxation of a partnership; and
  • fewer administrative and legal formalities than a corporation.

Furthermore, the Illinois Secretary of State recently reduced the filing fees for LLCs, thereby making the formation and maintenance of an LLC even more affordable.

The most important organizational document for an LLC is the operating agreement. The operating agreement lays the ground rules for the business and outlines the financial rights of the members, managerial duties and how the business will be sold or transitioned.

Because of the LLC’s prevalence, some hands-on business owners may form an LLC online by filing the Articles of Organization but miss the crucial step of creating and adopting a comprehensive and individualized operating agreement. Or worse, they use a general template found online that usually contradicts the goals of the owner. The failure to draft and enforce a proper operating agreement may be a costly mistake in the future if the business expands or runs into trouble. Without an operating agreement, the default laws contained in the state statutes govern disputes which may lead to unpredictable outcomes.

An operating agreement is a flexible document that should be structured to fit the operations and goals of the business. Below are a few of the key provisions highlighted in our personalized operating agreements that are generally absent from a “template” agreement:

Deadlock provisions
Particularly significant with two (2) member LLCs, a deadlock occurs when managers or members are evenly split on an issue and neither side will relent. Under default state law, deadlocks are remedied by judicial dissolution, a fatal outcome for the business. Instead, deadlocks can be solved pursuant to the terms of the operating agreement by a binding arbitration, member withdrawal, a third party tie-breaker or even a coin flip.

Right of first refusal
If any member desires to sell their membership interest to a third party, that member must first offer the interest to the remaining members and/or the company on the same terms and conditions as proposed by the third party purchaser. The remaining members and/or company will have a set time in which to determine whether to exercise their right of first refusal and purchase the interest or allow the sale to proceed to the third party.

Owners should decide whether profits and/or losses should be distributed equally among the members or tied to the amount of each member’s financial contribution if unequal. This may also include a preferred return of a member’s capital contribution.

Noncompetition clause
A non-compete prevents members from engaging in similar businesses that directly compete with the business within a certain radius and time period after termination of the business relationship. Non-competes are an easy method of protecting your business’ inner workings and confidential information.

Member expulsion or withdrawal
In the event of a fall-out between members, members should be allowed to force another member out at a certain purchase price to avoid expensive and lengthy litigation.

The operating agreement should outline the limitations and obligations of the manager and those items the manager must obtain member consent. For example, a manager may be required to obtain majority consent of the members if he/she desires to make a withdrawal from the corporate bank account greater than $5,000.

Tag along and drag along rights
Primarily used in situations where there are minority and majority members, these rights allow (i) the minority member to join a transaction and sell his/her minority interests if the majority member is in the process of selling his/her interest and (ii) the majority member to force the minority member to sell his/her interests in the event a third party purchaser desires to buy the entire business.  

Buy/sell provisions
When a specified trigger event occurs (usually death, withdrawal, divorce or failure to make additional capital contributions), the other members of the company may be obligated to buy that member’s interests to avoid alienation of the membership interests. All buy-out provisions should contain the exact method of (i) paying the purchase price (e.g., lump-sum, promissory note, insurance proceeds, etc.) and (ii) determining the purchase price (e.g., fair market value, book value, agreed upon value, etc.).

Contact a Chuhak & Tecson Corporate Transactions & Business law attorney to discuss how we can draft a custom operating agreement for your business tailored to protect your corporate interests. 

This Chuhak & Tecson, P.C. communication is intended only to provide information regarding developments in the law and information of general interest. It is not intended to constitute advice regarding legal problems and should not be relied upon as such.

Client Alert authored by: Christina M. Mermigas, Associate

This alert originally appeared in the Spring 2018 Corporate Focus newsletter.