Startups 101

The Limited Liability Company (LLC) Operating Agreement

July 2008

By Jon M. Garon*

This column is part of a series of book excerpts from Own It: The Law and Business Guide(tm) to Launching a New Business Through Innovation, Exclusivity and Relevance.

The Operating Agreement serves as the equivalent of an LLC's bylaws, providing the rules for all ownership transfer, voting rights, business activities, management structure, management authority and any other questions important to the success of the business.

The choice to attach the Operating Agreement to the Articles of Organization has the effect of publishing the document and making it publicly available. While this is often not a problem, privacy reasons may warrant avoiding publication. The benefit of publication is that any future purchaser of LLC interests is aware of the Operating Agreement, and cannot claim ignorance because it is a publicly available agreement.

In the absence of an Operating Agreement, state law provides the rules under which the business is conducted. Because LLCs are a much more recent legal development than corporations, there are far greater variations in the laws from state to state and many fewer legal cases explaining these laws. The effect is to make the disputes that arise under LLCs much harder to solve than corporation disputes - if there is no Operating Agreement. In contrast, a well drafted Operating Agreement provides the answers to the situations which arise within the LLC, greatly reducing the ability for confusion and dispute to arise as well as discouraging lawsuits among LLC members.

A well drafted Operating Agreement provides the answers to potential LLC problems, greatly reducing confusion and discouraging lawsuits among LLC members. This requires that the LLC be drafted to take advantage of the law in the state of formation for the LLC and to adjust the provisions to the significant personnel, financial, and operational aspects of the enterprise.

In an LLC, members are the owners of the LLC, while managers have the right, power and duty to conduct the business of the LLC. "Ownership" in this case means that the member has both an equity interest in the LLC and the authority to vote on limited aspects of the LLC. In the typical LLC, managers are also members, having both the ownership interest and the business authority. However, members can employ managers who have no ownership interests.

The managers work together as the officers and directors of the LLC, depending on the LLC provisions. In the start-up business, the entrepreneur may be the only manager, or there may be more than one manager. In companies based on inventors, the inventor, key investor and chief business executive may serve as the managers together.

One of the primary benefits of the Operating Agreement is the ability to draft the management clauses to give different managers different powers. In the case of an inventor-based company, for example, the LLC could provide that the inventor is a manager with primary responsibility for product research and development, while the business executive is the manager with primary responsibility for all marketing and financial decisions. The key investor under this hypothetical is a manager but has no duties. The voting rights of the managers could be distributed at 35% to the inventor, 35% to the business executive and 30% to the investor — meaning that so long as the inventor and business executive agreed, the investor would not affect decisions, but if they disagreed, the investor had a tie vote. Such a model can be used to overcome many business roadblocks and is much more easily achieved in a LLC compared to a corporation. Any other varying construction of voting rights and authority can also be designed by the parties.

The LLC can also specify the extent to which managers can act with individual authority as officers and the extent to which they must act as a group with formal meetings. The need to formalize the operation will be a function of the size of the management team and the degree to which there is disagreement and poor communication among the group.

In a manager-run LLC, members generally vote on only a few key decisions. They can vote to dissolve the LLC, replace the managers if the managers have resigned, amend the Operating Agreement, raise additional capital investments, and admit additional members. Most or all of the operational decisions are left to the managers.

For smaller companies, the managers can be eliminated entirely, and the members can serve as member-managers. Over time, however, ownership is often transferred by will, managers need to retire and other life-cycle changes occur. As a result, it may be preferable to plan ahead with separate provisions in the LLC for members and managers, even if initially there are no members who are not also managers.

Setting up the decision making authority of the managers and members is the most crucial aspect of the LLC. This is where the primary disputes are likely to develop, and because of the limits placed on the members, these provisions are most important to the non-manager members.

Another important provision related to authority flows from the ability of the members to remove the managers of the LLC. Ultimately the members, as owners of the company, have the legal right to remove the managers. The LLC will provide rules for exercising this power. Members generally vote based on their membership interests rather than the number of members. This voting is the same as the corporation model of "one share, one vote," designed to protect the ownership interests tied directly to the proportionality of ownership.

Membership power to elect and remove managers can vary depending on the need for independent managers or membership control. At one extreme, a simple majority vote of the membership interests, excluding the manager's interests, may remove managers without cause. Such a provision would provide strong membership oversight of the managers. More commonly, however, managers draft the LLC to severely limit the members' ability to remove managers. In these Operating Agreements, the members may be required to prove that the managers acted improperly.

Alternatively, the Operating Agreement may require that a high percentage of the members vote in favor of removal. To avoid the tremendous difficulties of establishing appropriate standards and methods of determining when a manager has acted improperly, the super-majority voting provision, which requires a high percentage of membership voting interests to remove the Managers, may be more practical.

State law will generally provide the ultimate limit on managers. Regardless of the LLC provisions, a manager who has breached the duty of loyalty to the company by stealing from the company or committing fraud can be terminated by the membership for cause. Theft and fraud are extreme examples of impropriety, however, so the LLC should always provide the members with some ability to remove managers when the conduct can be proven to be improper.

This is part of a series of book excerpts from Own It: The Law and Business Guide(tm) to Launching a New Business Through Innovation, Exclusivity and Relevance, which provides a step-by-step guide to developing successful start-up companies using concepts of intellectual property in all aspects of business planning and financing.

* Jon M. Garon is admitted in New Hampshire and California.

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