LLC Operating Agreements
Why Your LLC Needs an Operating Agreement
An operating agreement is a crucial document that sets forth the framework and rules for running a limited liability company (LLC). All members of a limited liability company may enter into an operating agreement to regulate the affairs of the company and the conduct of its business to govern relations among the members, managers and company. 805 ILCS § 180/15-5(a). It is in the best interest of an LLC to have an operating agreement, although it is not required by law in the state of Illinois.
If a limited liability company does not have an operating agreement, then state default rules apply. Those default rules may not be conducive to the objectives of the LLC and its members. For example, in many states, the default rules state that the profits and losses of the LLC are to be divided equally among the members of the LLC regardless of capital contribution. This is likely not the desired profit distribution structure for LLC’s where some investors have contributed more than others. The existence of an operating agreement can override the state default rules most of the time. However, the operating agreement may not: (1) unreasonably restrict a right to information or access to records; (2) vary the right to expel a member; (3) vary the requirement to wind up the limited liability company’s business; (4) restrict rights of a person, other than a manager, member, and transferee of a member’s distributional interest; (5) restrict the power of a member to dissociate; (6) eliminate or reduce a member’s fiduciary duty; or (7) eliminate or reduce the obligation of good faith and fair dealing. 805 ILCS § 180/15-5(b).
Further, these state default rules only provide a skeletal set of guidelines for an LLC. Therefore, the members of an LLC will want to draft their own rules, memorialized in the operating agreement. Negotiating the operating agreement during the initial formation of the LLC is preferred. This will allow for procedures, negotiated by the members of the LLC, to be in place later on if there are disagreements among the members throughout the course of business. Otherwise the LLC would be subject to the state default rules, which the members of the LLC did not negotiate themselves.
Another important reason why every LLC should have an operating agreement is for evidentiary purposes. This especially applies to single-member LLC’s. Having an operating agreement allows the courts to see that the business is being run as an LLC. The operating agreement will protect each individual’s personal liability from the business debts of the LLC.
What to Include in the Operating Agreement
The following are all items that members of an LLC should consider when drafting an operating agreement for their LLC:
Admission of a New Member – The default rule on admission of new members is that “after the filing of the articles of organization, a person who acquires a membership interest directly from the limited liability company or is a transferee of a membership interest may be admitted as a member with unanimous consent of the members.” 805 ILCS § 180/10-1. The members of the LLC may choose to lower the required approval of new members in order to prevent a single member from blocking the admission of a new member or the transfer of a member’s interest. The members may also choose for the operating agreement to provide for restrictions on the transfer of membership interests by creating a right of first refusal. A right of first refusal is a common clause in many operating agreements. It provides that if any member attempts to sell his or her membership interest, he or she must first offer that interest to the remaining members of the LLC on the same terms and conditions. The right of first refusal allows the remaining members to exclude the admission of a new member as they see fit, by purchasing the for-sale membership interest themselves.
Distributions – The default rule on distributions is that “any distributions made by a limited liability company before its dissolution and winding up must be in equal shares.” 805 ILCS § 180/25-1(a). The members of the LLC may wish to change this in their operating and opt for distributions to be made on a per capital basis. If an LLC does not have an operating agreement altering the default rule on distributions in 805 ILCS § 180/25-1(a), members who have contributed more capital to the business may feel undercompensated by the default rule distribution scheme. Choosing whether to distribute profits and losses on a per capita or per capital basis should be included in every LLC’s operating agreement.
Management – An Illinois LLC identifies whether it is member-managed or manager-managed within its Articles of Organization. In a member-managed company each member has equal rights in the management and conduct of the company’s business. 805 ILCS § 180/15-1(a). In a manager-managed company each manager has equal rights in the management and conduct of the company’s business. 805 ILCS § 180/15-1(b). When drafting an operating agreement, the members of the LLC should decide the scope and authority of the power of both the members and managers (if applicable), as well as, limitations on the authority of managers. Procedure for the removal of a manager should also be put in writing.
Other Provisions – The LLC’s operating agreement should also include more general provisions such as, each member’s percentage of ownership, the purpose of the business, rules for holding meetings, voting procedures and each member’s rights and responsibilities.
Without an operating agreement, an LLC is subject to the default rules of the state, which are not in-depth enough to cover many possible conflicts that may arise in the course of running an LLC. Therefore, a well-thought out operating agreement can greatly aid a business in resolving a conflict without subjecting the LLC to costly litigation.
If you are starting a new business or amending the management and/or operating guidelines for an existing business, Brotschul Potts attorneys are here to help you navigate this process and ensure that the management of your company fits your needs and desires. We are standing by to answer any of your questions and look forward to working with you.