Top 5 Questions to Ask Before Signing an LLC Operating Agreement

1. Who’s in charge, and how will decisions be made for the LLC?

A limited liability company, or “LLC”, is basically a partnership with the legal protections of a corporation. As with a traditional partnership, the partners – or “members” – of an LLC need to decide how decisions will be made. Most LLCs are either “member-managed” or “manager-managed”. The former means that all of the members together manage the LLC, while the latter means that one or more managers will manage the LLC. A partnership is usually governed by a partnership agreement, which sets out how the partnership is governed, and the various rights and obligations of the partners. An LLC has an “operating agreement” that is similar to, and serves the same purpose, as a partnership agreement.

For LLCs with just 2 or 3 members, decisions can be made either unanimously or by majority vote (which usually means majority of membership interests, or percentage ownership, and not majority of members). This simple arrangement makes sense if the members know each other well and have a strong relationship based on trust and prior collaboration.

However, for an LLC with more than 3 or 4 members, or an LLC with just 2 members who do not have a shared work history, a more detailed decision-making process is necessary. For routine matters, a simple majority of membership interests is usually acceptable. But what about key decisions, such as admitting new members, or selling the LLC, or changing its business focus, or raising new capital from outside investors or lenders, or incurring significant debt to expand the business, upgrade infrastructure or invest in new technologies? Those are just a few of the types of important decisions that will affect all members.

A common way of balancing this tension between democratic (majority-rule) governance, and the need to give dissenting or minority shareholders a voice, is to require a “supermajority” vote for such decisions in the operating agreement. The required vote percentage is a matter for the members to agree on, but a common formula is to require the affirmative vote of at least 2/3 of the membership interests.  A lower bar would be more than 50% of the membership interests, which is often the same as 2/3 if there are only 3 members.

In some cases, even if there are multiple members, one or two members may be the driving force behind the LLC. They may bring all or most of the start-up capital, or they may have highly valuable skills or relationships that will add considerable value to the LLC. The other members may play a more passive role either because they’re investing a comparatively small amount of capital, or they’re contributing only specific or limited services or know-how. In these situations, the members may agree that it’s logical and fair that the “principal members” have disproportionate control over decision-making. In fact, many passive minority members want the driving members to be in control, because of their superior knowledge or skills. Thus, certain key decisions may be left to the sole or joint discretion of the principal members.

2. Who will fund the LLC if more capital is needed?

In the start-up phase of a new LLC, the members will usually discuss an initial budget before the members have made their initial investments. But what if the money runs out before the initial goals are achieved, or before the LLC starts generating revenues? In certain industries like life sciences, it is understood and expected that a start-up will “bleed cash” for months or years before a promised technology achieves success in the marketplace. In most other industries, members would expect to recoup their investment within a reasonable period of time, at most a few years.

A problem arises when a new LLC burns through cash faster than the members had anticipated. In the start-up world, a common phrase is “runway length”, which is an offhand way of asking how much money – or “runway” – the business has left. For a promising LLC that is desperate for new capital, new investors bringing fresh capital can be expected to exploit those circumstances, and bargain for more equity at a lower valuation. For an “ordinary” LLC that is not shooting for the moon, shortfalls in operating capital can only be remedied if the LLC secures new loans or lines of credit, or if the existing members add to their initial investment, or make additional capital contributions.

Partnerships refer to the latter as a “capital call”, which is what happens when the general partner (or the manager or majority of membership interests in an LLC) requires limited partners (or other members of an LLC) to make additional capital contributions so that the LLC can continue operating for some period of time. In practice, capital calls are a highly sensitive issue since passive or minority partners or members are reluctant to accept an open-ended liability to make additional investments, especially if the LLC’s prospects are uncertain. Some LLC operating agreements provide that members will not be required to make additional capital contributions against their will. That essentially leaves open the question of who will fund ongoing needs if the LLC’s capital runs low and there are no options for external funding (either new investors or debt). In such event, one or more members will have to step up and invest additional capital for the LLC to continue operating (and in such event, the additional capital will usually increase the membership interest percentage of the contributing members, and dilute, or reduce, the membership percentage of the non-contributing members).

3. Will the members be allowed to sell their membership interests or exit the LLC ?

For any number of reasons, such as a need for liquidity, at some point some of the members may wish to sell their membership interests and/or resign from the LLC. Remaining members might object to a sale because the purchaser of the selling member’s interest will now become their partner as a new member of the LLC. If the purchaser is not reputable, or is competing with the LLC, or has interests that conflict with those of the LLC, the remaining members could be negatively impacted. Alternatively, if the selling member has found a buyer who is willing to pay an attractive price, other members may wish to sell their interests as well.

Resignation may also present issues if the resigning member wants the LLC or the remaining members to buy out his or her interests. Even without a mandatory buy-out, the mere act of resigning could negatively impact the balance of voting power among the remaining members, or result in that member avoiding certain responsibilities or obligations that should be shared equally among the members.

For those reasons, it is common for the members to agree in their operating agreement that no member may resign or sell their membership interests without the consent of the other members (either all or a majority of interests). This restriction, for better or worse, places all members on an equal footing.

In multi-member LLCs, it is common to include in the operating agreement a restriction sometimes referred to as a “drag and tag”. A drag right means that if a controlling member (usually the holder(s) of a majority of membership interests) finds a buyer who wishes to buy out all of the members and purchase the LLC, the controlling member can “drag” along the other members and force them to sell on the same terms and for the same price. At first glance this right may seem unnecessary, since presumably the controlling members would only sell on favorable terms, and presumably the other members should be pleased to sell on the same terms. However, without a drag right, some of the minority members could hold up the transaction by demanding an even higher price or additional benefits. Also, most purchasers of a controlling interest in an LLC will want to acquire 100% of the membership interests and become the sole owner. A drag right allows the controlling members to “shop the company” without having to negotiate terms in advance with each individual member.

Similarly, a “tag” provides that if any member receives a “bona fide offer” from a prospective purchaser, the other members must be notified and offered the right to sell their shares on the same terms, usually on a pro rata basis. For example, if an LLC has 5 equal members (20% membership interests each), and one member receives a buy-out offer, the remaining members would have to be notified and given the same right. If all 4 members choose to exercise that right, then each member could only sell a pro rata portion of their membership interests, or 20% each. It is somewhat rare for a purchaser to want to purchase only a minority interest in a private LLC, but it does happen (e.g., for tax-loss sales among members). As a practical matter, though, the tag right usually applies when a controlling member has found a Buyer that is content with owning only a controlling interest. In that case, the tag right ensures that the remaining members will have the opportunity to sell a pro rata portion of their membership interests in the same “exit event” as the selling controlling member.

4. What happens if a member dies, or becomes sick or disabled ?

Because an LLC is akin to a partnership, the untimely death, illness or disability of a member can raise numerous issues for the LLC and the other members. If the affected member is a passive investor, with little or no involvement in management and direction of the LLC, the impact will probably be minimal. But if the affected member is also the manager, or has specialized skills or knowledge critical to the LLC’s success, that member’s absence will likely have a profound effect.

There are several ways to manage and mitigate the impact of a member who passes, or who becomes unable to continue to participate in the affairs of the LLC. One common mechanism is to include in the operating agreement (or in a subsequent agreement) a “buy-sell” agreement. While the terms vary, most buy-sell agreements provide a mechanism to determine the buy-out price of an affected member’s interest, and whether other members can be required to fund the purchase. Alternatively, the members may wish to allow the affected member’s executor, guardian or designated representative to continue holding the membership interest, but without any voting or management rights.

Though not mandatory, it is both prudent and common for the LLC to take out “key man” life insurance on the members or managers most important to the LLC. This type of insurance protects both the LLC and the other members by providing a death or disability benefit to the LLC itself. In most cases, the LLC would then use the proceeds to buy out the affected member’s interests. However, if the affected member’s family or heirs wish to retain the interest, and the LLC consents, then the insurance proceeds could instead be used to hire new professionals.

5. How will disputes be resolved?

Just like the best of marriages, even the best business partnerships will be tested and face their share of ups and downs. Most of the time LLC members are able to work things out by focusing on their shared interests in seeing the LLC continue to grow and be profitable. Still, there are any number of circumstances that may create “irreconcilable differences” among members with equal voting power or other forms of leverage. Just like a marriage that has run its course, an LLC that can no longer be operated by its members, either due to fundamental and irresolvable disputes, or a lack of needed fundings, or some other cause, must be dissolved. Generally that is accomplished by paying off any remaining debts of the LLC and filing articles of dissolution. But, like a dissolving marriage, “business divorces” can similarly range from amicable to deeply hostile. If the members cannot resolve their differences over how to dissolve the LLC (and often, who owes what to whom), often the only recourse is judicial dissolution or bankruptcy. In either scenario, ultimately the courts resolve these issues one way or another. Therefore, it is always best practice to provide a dispute resolution mechanism in the Operating Agreement (a common option is binding arbitration, sometimes with mandatory pre-mediation).