I wanted to talk about LLCs and operating agreements. A lot of people will form an LLC by going to the Secretary of State’s Office often online in most states and file articles of organization and articles of organization are pretty straight forward. It’s quick to do. You can go online, answer the questions and create an LLC in just minutes.
That’s great for getting that part of it done, but especially if there are two or more owners or members of an LLC, you’re going to want to have an operating agreement also. The state law provides for a number of rules and regulations by which you must operate your LLC, but with the operating agreement you can adjust some of those rules and regulations and set the standard for what you want in your business.
Now, with an LLC, the operating agreement defines how you’re going to operate this LLC, thus the name. One of the first things in a well-crafted operating agreement is simply identifying who the members are, who the owners of the LLC are. The operating agreement should include the names and addresses of those owners. Sometimes a group of people get together and form an LLC and not everyone is intended to be an owner. Perhaps some of them are meant to be owners and others to be employees of that LLC.
We want to be clear about that so there are no misunderstandings going down the road. That’s important to make sure that you’ve covered who the members are. It should also cover how new members can be admitted to the LLC and how old members go away should they decide to leave or move on. Sometimes people retire, they die, they get divorced, they just want out. There should be a methodology for how people get in and for how people get out.
Another important point is you can share profits and losses and cash distributions from LLCs in a variety of ways. If there’s three members of the LLC, that doesn’t mean that the three of you need to share those items equally. One person could be a 50% owner and the other two 25% owners. You can share profits and losses differently than cash distributions in certain cases if you draft the document correctly. You want to be clear. You don’t want there to be misunderstandings amongst the members as to how you’re going to do that.
You can run into that sometimes when perhaps you have one member who is a services member, somebody who is doing the day to day work and another member who’s a little bit more silent. They put maybe the cash into the deal, the capital in order to get it going. We want to be clear what their rights are, what they’re entitled to in that LLC. That’s an important factor to make sure that you’ve got covered.
Another important issue is the buy/sell agreement. Not only do we need to know how people come and go, but the buy/sell agreement, that portion of the LLC talks about how we’re going to determine what someone’s share of the LLC is worth and how quickly they’ll get paid off. Those are two of the important issues in the buy/sell provision in the operating agreement. Because let’s say we have three members and one of them decides to go away. He thinks his interest is worth $100,000 and the other two people think his interest is worth $25,000, how are you going to settle that? It’s going to be an ugly situation unless you’ve’ dealt with it upfront.
One thing we have to always remember is that in most business organizations, when you create that organization with multiple members or multiple owners, undoubtedly one or more of them is going to go away, again, whether it’s their choice voluntarily, they retired, they died, they got divorced or whatever, it happens frequently and we don’t want to have disputes. It’s easier to set the terms to decide how we’re going to value that interest and how quickly someone’s going to get paid their capital.
I’d like to decide that upfront while everybody is still friends than on the back end when you have a difficult situation going on. Especially you think about if someone died. Now you’re dealing with the family heirs and they may not have the same interests that you have. They want their cash out of the business right now and that may be very detrimental to you. The operating agreement can control issues like that.
There’s a number of things that go into a well-crafted operating agreement and if you don’t have one and you form an LLC, you’re best off to visit with someone who understands operating agreements and can give you some advice on that. Typically an attorney. Thanks for reading this post on operating agreements and LLCs. I hope that if you don’t have one, that you take action soon and solve that.