Deciding on the entity form to use for your business depends on a number of factors, but for many entrepreneurs, an LLC is the best fit. An LLC is a hybrid entity as it provides liability protection similar to a corporation and favorable income tax treatment similar to a partnership. If you are starting or currently operating a business through an LLC, your most important organizational document is the agreement between you and your partners: the Operating Agreement. An operating agreement establishes the internal operations of the business in a way that suits the specific needs of the business owners. Once signed by the members of the LLC, it is an official binding contract.
Another benefit of using an LLC to operate your business is the flexibility LLC owners have to structure their operations and business relations with their partners. While the Kentucky Limited Liability Company Act contains default provisions for many of the organizational issues that may arise, members of an LLC may agree to operate under provisions other than the Act’s default provisions. No matter the nature of your business, your LLC should have an operating agreement that includes details such as voting rights and responsibilities, powers and duties of members and managers, allocation of profits and losses, and distribution of capital, whether the members agree to use the LLC Act’s default provisions or alternatives to the default language.
As an example of the flexibility of the Act, and also of the importance of carefully considering the effects of each section of your operating agreement, consider the following three provisions that will help your business run smoothly.
1. Transfer provisions.
An operating agreement typically contains some language about the circumstances under which a member may or must transfer his ownership interest in the LLC to another person or entity. Under the Act, a member may freely transfer membership interest to anyone. There are a number of provisions in the Act that tell us how the transferring member and the new owner are to be treated, one of which is that the new owner will not be a full member with the right to vote unless a majority of the other members vote to make the new owner a full member. If members are allowed to freely transfer their interests however, founding members may find themselves faced with new business partners they did not approve. Moreover, a member’s interest could be transferred involuntarily, such as by death, divorce, or bankruptcy. For these and other reasons, you and your business partners may decide on a transfer provision that would limit uncertainty in these situations. Terms in the operating agreement may require a majority of members to vote to allow a proposed transfer before it can occur, or give the company or the members a right of first refusal to purchase the membership interest subject to a proposed transfer. The members might agree to purchase life insurance policies to provide the funds to purchase the membership interest of a member at death. The operating agreement may also prohibit members from pledging (granting a lien on) membership interest. Putting restrictions on transferability gives members control over when, how, and why membership interests are transferable.
2. Deadlock provisions.
Management or member deadlock occurs when a company’s decision makers are evenly split on a matter and neither side will relent. It is a potentially fatal problem and, thus, should always be addressed within the operating agreement. Under the Act, the remedy for deadlock is judicial dissolution. A court “may dissolve a limited liability company in a proceeding by a member if it is established that it is not reasonably practicable to carry on the business of the limited liability company in conformity with the operating agreement.” Once the LLC is dissolved, it cannot carry on business, but must wind up and liquidate its business. There are, however, many strategies that can be put into your operating agreement to avoid this problem:
· The opposing member may be allowed to withdraw from the LLC.
· The operating agreement may require that a deadlock at the manager level be subject to a vote of the members.
· The members may agree to be bound by a coin flip.
· The members may be required to take the issue to binding arbitration.
· The members may incorporate a buy-sell provision that would require one member to provide a purchase price to the other member and then require that other member to purchase or sell the membership interest in the LLC at that purchase price such that the selling member ceases to be a member of the LLC.
With each of these strategies, the common feature is that the LLC is likely to continue as a functioning business after the deadlock is resolved.
3. Additional Capital Contributions.
A company operating agreement will usually state the amount of money or the value of property each member initially contributes to the company for operations, known as initial capital contributions. As an example, three people may decide to start a business and agree that each of them will give the company $3,000 so the company has $9,000 in start-up capital. Most operating agreements also have language about additional money from the members, known as additional capital contributions. Because the Act allows flexibility here as well, that language may state that members are not required to make additional capital contributions, or it may require additional capital contributions and allow for one member to make an additional capital contribution for another member that fails to make that contribution when due in exchange for a portion of that member’s membership interest. There are many possibilities. But frequently, when considering these possibilities, members fail to consider the effect of the additional capital contribution language on the limited liability feature of the LLC.
One important function of an LLC is that the members are not individually liable for the debts of the LLC if the LLC cannot pay its creditors. That protection from individual liability is not absolute, however. Among other things that may cause a court to ignore limited liability protection, including fraud, intentional misconduct, or the failure to maintain a real distinction between the LLC and its members, the additional capital contribution language can be read to require the members to pay LLC debt that the LLC cannot pay itself. The members may avoid this by affirmatively stating in the operating agreement that additional capital contributions are never required and the members have no personal liability for the debts of the LLC, but that may cause problems later if the LLC needs additional capital. The members may instead decide to have additional capital contribution language, but to have it drafted carefully so as to avoid unintentionally negating the limited liability protection generally afforded by the LLC. The important thing is to consider and plan for the potential needs of the LLC, and to do so in a way that doesn’t result in unintended consequences for the LLC or its members.
Every successful business encounters bumps in the roads. An operating agreement is a road map, a tool to navigate through the difficult obstacles.