November 2018

The Importance of a Custom-Drafted Operating Agreement

The Operating Agreement of a Limited Liability Company (LLC) contains the fundamental understanding among its members from how the company will operate to the members’ respective rights and obligations, such as issues like voting, ownership and management rights, exit clause, valuation of membership interest, resolving disputes among the members and more.
Owners of an LLC are focused on growing the business, negotiating contracts, developing products, applying business strategies, hiring the right team and raising capital, all while protecting their own interests. Above all, your LLC’s most important contract is the one that governs the relationship between its members: the operating agreement. An Operating Agreement should be written according to its members desires and intentions.
A custom-drafted Operating Agreement is critical for the following reasons:

Ownership and Management
It is very common for third parties to ask for proof of ownership of an LLC. The Operating Agreement signed by all members is the most important document to establish ownership. The Articles of Organization filed with the Secretary of State does not disclose the owners. The Operating Agreement also establishes whether the LLC is member managed or manager-managed.

Open a Bank Account
Some banks will require an Operating Agreement to open an LLC’s bank account.

Allocation of Profits and Losses
The Operating Agreement may set forth how economic profits and losses are allocated among the members and how and when distributions will be made. The amount and timing of distributions respond to management’s discretion, required at established times or triggered by certain events. LLC Operating Agreements sometimes include both required and discretionary distributions.

Prevents a Member from Claiming That There is an Oral Operating Agreement
Oral agreements are open doors to legal disputes.

Restrict Transfer of Member Interests
Without a written Operating Agreement signed by all the members of an LLC, any member is free to transfer all or a portion of the member’s membership interest to any person or entity for any consideration or no consideration. That restriction assures that the parties will continue to do business with the same people, and not strangers. The Operating Agreement can restrict a member from selling her or his interest to third parties.

Exit Strategy and Valuation Method
When a Member wants to sell his interest in the LLC due to a foreseen or unforeseen circumstance, the Operating Agreement can prevent further disputes if Members agree to a valuation process, alternatives and approach incorporated to the Operating Agreement.

Redemption of a Deceased Member Interest
An Operating Agreement may also provide for redemption of the interest of a deceased member for a price to be determined by appraisal or by a formula. In that case, the Operating Agreement should specify where the funds for the redemption will come from.

Compel a Member to Fulfill its Monetary Obligations with the LLC

Expel a Member from the LLC

Avoid Probate on the Death of a Member
A member of a California LLC can include a statement in the written Operating Agreement that on the member’s death his or her membership interest will pass automatically without a probate to the person, people, entity or entities named in the Operating Agreement.

This blog is intended for general information and does not provide legal advice. We recommend speaking with a lawyer to formulate an strategy for your specific case.