Making Sense of a Limited Liability Company's Operating Agreement

Browse any introductory textbook on Economics or Corporate Finance and you will find a section that discusses three legal structures, Sole Proprietorships, Partnerships, and Corporations, under which businesses typically operate. These introductory textbooks however, often exclude a fourth, more recent structure, the Limited Liability Company or, abbreviated, the LLC.

Overview of the Limited Liability Company

The Limited Liability Company is in a sense, an entity that is a hybrid of a Partnership and Corporation and, as a result, is one that provides its organizers some of the benefits of both. Like a Partnership, a Limited Liability Company is generally created as a pass-through entity. This means that all of the company's profits and losses are incorporated into its owners' individual federal and state income taxes. If you were one of the owners for example, the profit or loss from your LLC would show up on your 1040 as income and would be taxed at your individual tax-rate.

This pass-through nature of profit and loss lets you avoid the double-taxation issues commonly associated with a Corporation. Another major benefit of an LLC is that it literally limits the liabilities of each owner. Owners of a Limited Liability Company are not responsible for the company's debts and other obligations, nor are they legally responsible for the other owners' debts and obligations. Investors and owners only risk losing the capital they contributed.

The Operating Agreement

The Operating Agreement is simply an agreement between the founding members that specifies the obligations and rights of each member, the manner in which the company will be governed, and among other things, the allocation of profit and loss between the members. Here is a cursory overview of the major sections of an Operating Agreement.

Organizational Matters

This section (a) provides for the formation of the business, (b) specifies any restrictions on the name of the LLC, (c) specifies the company's registered agent and registered office, (d) specifies the company corporate headquarters, (e) discusses its purpose and any restrictions on its purpose, and (f) outlines the company's duration. Given the uncertain nature of startup companies, one should explicitly state that there are no limitations on the type of business the LLC can conduct. Often times the idea you begin with will not be the idea that makes your business solvent.

Members and Capital Structure

This section specifies (a) the name and address of each of the members, (b) each member's percentage ownership in the LLC, (c) the initial capital contribution made by each member and whether members are required from time to time, to make additional capital contributions, (d) whether loans or services are considered capital contributions, (e) the terms under which new members are added, and (f) whether the members have limited liabilities and if they are personally liable for the obligations of other members .

Governance of the Company

This sections specifies (a) if the company is to be managed by its members or if day-to-day management is to be delegated to employees, (b) the rules and procedures that govern formal company meetings, (c) the actions, such as a sale of the company, that require unanimous member approval, (d) the amount of time each member is required to dedicated to the venture, and (e) rules governing the use and withdrawal of the company's funds.

Accounting and Records

This section determines how frequently and for how long financial records are available for inspection by the members. More importantly, the section specifies whether the LLC is classified as a pass-through entity, which member is responsible for tax-related matters, and what the company's fiscal year (typically January 1st to December 31st) will be.

Allocations and Distributions

This section specifies (a) the allocation of net income, net loss or capital gains, (b) the distribution of capital, whether there are restrictions on these withdrawals, and how frequently available cash is to be distributed, (c) whether the company can withhold a portion of the cash distribution to comply with federal and state law, and (d) whether members are liable for wrong or erroneous distributions.

Restrictions on Withdrawal and Transfer of Ownership Interests

This section specifies (a) the terms and conditions under which a member may withdraw from the company, (b) the restrictions on the transfer of a member's ownership interest, and (c) how a purchase price for the transfer of ownership interests is determined .

Dissolution and Winding Up

This section specifies (a) the terms under which the company may be dissolved, (b) the manner in which the company will be liquidated, (c) and how the company's assets will distributed upon the winding up of business.

Long, but not complicated

Phew! As you can see the Operation Agreement is lengthy document. It is not however, terribly complicated. Just remember the need for legal protection and rules for practically every conceivable hypothetical scenario. What happens if a member decides to leave? What if one, heaven forbid passes away? What if you want to bring on a new part-owner? All of these, and many others questions are covered by the Operating Agreement. While you can obtain a simple agreement through a company like LegalZoom, you should not operate a Limited Liability Company without one.