Operating Agreements: Safeguarding Your Interest in an LLC
Limited Liability Companies (LLCs) have become increasingly popular business structures due to their flexibility and liability protection. An essential component of an LLC’s governance is the operating agreement – a contract outlining the company’s ownership, management structure, member rights, and responsibilities. For members of an LLC, ensuring their interest is adequately protected within the operating agreement is of paramount importance. Let’s explore ten pivotal strategies that members can employ to safeguard their interests effectively via the effective use of an operating agreement.
1. Precise Ownership Structure and Percentage Allocations
The most fundamental provisions of any operating agreement are those delineating ownership, as this often forms the basis for for profit sharing, control, and contributions. The default in Nevada, is that one’s membership interest is proportional to the capital accounts of each member, as adjusted from time to time. See NRS 86.091; NRS 86.341. However, this should be modified via the operating agreement as establishing each parties capital account can quickly become convoluted in light of the fact that Nevada law defines a capital contribution as “tangible or intangible property or any other benefit to the limited-liability company … including… money, real or personal property, services performed, or a promissory note or other binding obligation to contribute cash or property or to perform services.” For example, valuing the services provided introduces uncertainly. To avoid this issue, it is typically best practice to expressly assign a percentage interest to each member. Ultimately, no matter how simple or complex the intended ownership structure is, clarity is paramount. Members should ensure that the agreement explicitly delineates the ownership structure and spells out each member’s ownership percentage to avoid any unnecessary litigation in the future.
2. Voting Rights of Members
A robust operating agreement leaves no room for ambiguity as to voting rights. Typically, members of an LLC may vote in proportion to their percentage membership interests and the vote of the majority in interest controls. However, under different scenarios, it is desirable for the operating agreement to set up different classes of members that have different rights and responsibilities (e.g. voting and non-voting members), provide certain members veto rights, and to delineate which, if any, major decisions require the unanimous or supermajority vote of the members (e.g., altering the company’s management structure, admitting new members, or executing substantial financial transactions). NRS 86.296. Well-defined decision-making processes ensure that each member’s voice is heard and that significant determinations align with their best interests.
3. Articulation of Decision-Making Protocols by Management
An effective operating agreement should clearly delineate the company’s management structure. This clarity helps prevent power struggles that could potentially debilitate the operations of the business. The default in Nevada, is that “management of a limited-liability company is vested in its members proportionally” to “the total contributions of the members to the capital of the limited-liability company, as adjusted from time to time to properly reflect any additional contributions or withdrawals by the members.” NRS 86.055 and NRS 86.291. In other words, the default is that a Nevada LLC will be member-managed. However, there are many instances (e.g., a large business with members that are passive investors), where members may want the LLC be manager-managed. In such cases, the operating agreement should directly discuss how members will appoint management, manager duties and responsibilities over day-to-day operations, how managers may be removed and appointed by members if necessary, etc.. If there are multiple members in a member managed LLC or managers in a manager-managed LLC, the operating agreement should set forth whether they each act independently, must act by majority, or must act with unanimity. If there are an even number of managers who must act by majority, the operating agreement should also include a provision that dictates how deadlocks are resolved. In sum, a well-drafted operating agreement will painstakingly address each management scenario and be molded to the unique characteristic of each business.
4. Transparency in Capital Contributions and Financial Responsibilities
Financial commitments drive an LLC’s trajectory. Members should scrutinize the operating agreement’s provisions related to capital contributions, ensuring that they comprehensively address initial investments and lay out protocols for additional contributions. Similarly, clear guidelines for profit and loss allocations among members must be in place. This transparency not only cultivates fairness but also prevents scenarios where one member bears an undue financial burden or is unfairly excluded from reaping the rewards of their investment.
5. Comprehensive Exit Strategies and Contingency Planning
Change is inevitable, and a well-structured operating agreement accounts for various exit scenarios. Members must advocate for provisions that cover scenarios for when a member sells his or her interest, is subject to bankruptcy proceedings, retires, passes away, etc.. For each such scenario, the operating agreement should set forth: (a) the member consent requirements, (b) any rights of first refusal, (c) any transfer restrictions, and (d) the valuation procedures for the subject interest. The operating agreement may also expressly permit certain transfers (e.g., transfer of interest into a trust for estate planning purposes). In addition, in the unfortunate event of a member’s incapacitation, a well-crafted operating agreement should provide guidance on how the business will proceed. This could involve assigning temporary decision-making authority, recognition of a member’s power of attorney, detailing buyout options, or clarifying how the member’s interests will otherwise be handled until they regain capacity.
6. Winding Down and Dissolution Protocols
Members must also establish wind down protocols for the orderly dissolution of the company. Such protocols should, at minimum address: (i) the circumstances that trigger dissolution (e.g. unanimous vote of the members, expiration of a specified term, or the occurrence of a specific event), (ii) the filing of final tax returns, cancelling business licenses and permits, closing bank accounts, and the dissolution resolution with the Nevada Secretary of State (iii) the procedure for notifying creditors and satisfying all debts; and (iv) how the assets will be distributed. Robust language outlining the mechanisms for transferring interests and dissolving the company safeguards members and provides needed direction in times of uncertainty.
7. Mitigation of Potential Conflicts Through Dispute Resolution
Even the most harmonious partnerships can encounter conflicts. An operating agreement should anticipate this reality by incorporating alternative dispute resolution mechanisms. These mechanisms, such as mediation or arbitration, provide structured avenues for resolving disputes and preventing minor issues from spiraling into drawn out and expensive litigation. Provisions that dictate that the non-prevailing party in a lawsuit is required to pay the attorney’s fees and costs of the prevailing party also have the effect of disincentivizing lawsuits by significantly increasing the financial risk of pursuing the same. Addressing potential conflict resolution mechanisms upfront will help maintain cohesion among members and thereby preserve the business’s overall health.
8. Inclusion of Non-Compete and Non-Disclosure Provisions
To protect the company’s interests, operating agreements can include non-compete and non disclosure provisions. These clauses restrict members from engaging in activities that could harm the company’s competitive edge or reveal proprietary information. By safeguarding against unfair competition and information leaks, these provisions bolster the company’s long-term viability.
9. Flexibility for Future Amendments
Business landscapes evolve, and so should operating agreements. “Unless otherwise provided in the operating agreement, amendments to the agreement may be adopted only by the unanimous vote or unanimous written consent of the persons who are members at the time of amendment.” NRS 86.286(1). This should be expressly confirmed in the operating agreement. This flexibility enables the LLC to adapt to changing circumstances while ensuring that all members have a say in any modifications.
10. Addressing Limited Liability, Tax and Regulatory Matters
Operating agreements should incorporate provisions that address tax allocation methods and compliance with regulatory requirements. Clarity on tax responsibilities prevents disputes and ensures equitable distribution of tax burdens among members. Similarly, adherence to regulatory obligations preserves the LLC’s standing and prevents potential legal complications. Lastly, the operating agreement should clearly establish the LLC is a separate legal entity from its members and that the personal assets of the members are generally shielded from the company’s debts and liabilities. This reinforces the limited liability protection afforded under Nevada law of limited liability companies.
In conclusion, an LLC’s operating agreement serves as a critical shield protecting the interests of its members. By focusing on the foregoing ten key strategies members can establish a solid foundation for a harmonious and prosperous LLC. Collaborating with the legal professionals at Solomon, Dwiggins, Freer & Steadman, Ltd. during the drafting or review of an operating agreement is advisable to ensure that your interest as a member is protected given your businesses unique circumstances.