When several people come together to do business, have an understanding of how the percentages of ownership interest will be divided, and decide to form a limited liability company (LLC), they as the owners of LLC are called members. (As a comparison the owners of a corporation are shareholders. Different type of entity involves different legal terminology). The next step is to consider various elements of company management, owners’ rights and responsibilities, exit strategies, warranties and other matters, which may affect business operations. LLC operating agreement combines all of the said agreements and regulates the way business is conducted as well as the relationships between the owners of the LLC. The goal of the Agreement is not only to establish certain rights and procedures relevant to the present business goals, but to predict all possible future case scenarios and stipulate in advance how each will be resolved. Trying to deal with a problem when it emerges without having a certain plan or understanding will undoubtedly lead to disagreements and protracted litigation. Accordingly, LLC Operating Agreement should be a detailed all-inclusive document developed by an experienced business attorney.
Many various provisions may be included in the LLC Operating Agreement depending on the nature of business and relevance of each. I’ll review the most common and important ones.
Management Provisions
Management provisions in the Agreements are critical to effectively manage and control the operations of the company. The Agreements will set out the authority of each person, including the directors and officers which may include all of the Five C’s previously discussed. These agreements address in detail who may participate in the daily operations of the company, how decisions shall be taken and transactions be communicated to other members, inspection rights, compensation and many others.
Voting Provisions including Supermajority Voting Requirements
The Agreements will also set out the voting provisions. Usually all decisions are made by simple majority of the voting shares/membership interest (51%). The owners may negotiate in the Agreements that certain provisions (e.g. election of the board of directors, making changes to the Articles of Incorporation or the Agreements, issuing additional shares/interest, approving budgets, selling company assets, approval of the transactions with the affiliates, and capital contributions) require supermajority voting (75% of votes or above).
Restricting Transfers of Shares/Membership Interest
The Agreements should clearly set out any restrictions or obligations related to the shares/membership interest of the company and will typically include a general prohibition on transfers, or any rights or obligations under the Agreements except as specifically permitted in the Agreements or as consented to by the owners. There normally is some flexibility built into the Agreements so that owners can deal with their business interest efficiently for tax planning purposes – known as “permitted transfers”. For example, where the owner is an individual (e.g., a founder), such owner should ensure that the Agreement permits him to transfer his interest to a corporation wholly-owned by the owner or his family members, a custodian, trustee or other fiduciary for the owner and/or his family members, or any other person if such transfer is effected pursuant to the owner’s will. In case of a permitted transfer, the Agreement should state that any transfer is conditional upon the transferee agreeing to be bound by and becoming a party to the Agreement.
Confidentiality, Non-compete and “Assignment of Invention” Provisions
In a startup product or technology companies, the product idea or technology under development is often the most valuable asset of the company. It is critical to have not only confidentiality agreements respecting the confidential nature of the company’s information, but in many instances, noncompetition agreements with key employees and founders. The company must restrict those who have the capacity to impact the company’s success if their knowledge developed in connection with their service to the company or knowledge/product idea which they or others sold or transferred to the company for consideration, could be harmful if made public or used in competition with the company or transferred to a third party for use.
In the technology and product development communities, Assignment of Invention agreements are required to the extent such key employees or founders have rights to the same under law. These rights can be both brought to the company upon employment or can be acquired during employment as services are provided, so both instances must be covered. There are also Assignment of IP and Other Assets agreements entered into in which the owner of rights is assigning and contributing those rights to the company in exchange for compensation –which could be ownership equity in the company. It is also proper to have the spouse of the assignor sign these agreements to avoid any claim of marital property rights in the asset being assigned.
Other Common Provisions
Shareholders Agreements and Operating Agreements may also contain other provisions relating to the following:
- Anti-Dilution - in order to prevent their ownership interest from being diluted by future issuances of shares, the owners may require that they be given the right to maintain their percentages of ownership by acquiring a proportional number of any new shares issued.
- Right of first refusal - if an owner wishes to transfer his or her interest in the company, the company and other existing owners may request that first they are given the opportunity to buy the interest pursuant to the terms being offered by the third-party purchaser. If they fail to purchase the interest within prescribed time period, the selling owner is free to sell to the identified third party on the terms presented to the company and the other owners within a designated time period.
- Valuation - it is critical that the method of valuing shares and membership interests be set forth. Valuation methods may change depending upon who the member or shareholder is that requires the valuation and the circumstances requiring the valuation to occur. Death, disability and withdrawal of an owner being the most common. In the startup venture arena, valuation for purposes of investor equity is of huge importance and impacts further investment potential once valuation is determined.
- Payment Terms - once valued, if shares or membership interests are to be repurchased, the terms of repayment (number of payments, down payment, interest rate, security, voting during repayment, default rights) must all be put in place at the time the interests are reacquired by the company or a third party (if permitted as a transferee).
- Co-sale agreement – the owners may negotiate in advance that no third party can buy more than 10 percent of the interest in the company unless it purchases on a pro-rata basis the shares of all other owners who wish to sell at the price offered by the third party.
- Indemnification Provisions – it is important to include in the Agreements that the company shall indemnify any person who was or is a defendant or is threatened to be made a defendant in a legal action, suit or proceeding, whether civil, criminal, administrative (unless brought by the company itself) by reason of the fact that he/she is or was an owner, manager, employee or agent of the company or is or was serving at the request of the company, against expenses, judgments, fines, and amounts paid in settlement actually and reasonably incurred in connection with such legal action, suit or proceeding if other owners determine that he/she acted in good faith and in a manner he/she reasonably believed to be in the best interest of the company, and in case of a criminal action proceeding, has no reason to believe his/her conduct was unlawful.
- Jurisdiction and Governing Law - important to be clear if the requirements of law of a particular jurisdiction are to be applied and a convenient forum used in the case of litigation.
- Death, Incompetency, or Bankruptcy of Member - the owners may agree that on the death, adjudicated mental or physical incompetence, or bankruptcy of a member, the company or other members should have the rights to buyout the interest of such member at a price determined by the independent appraiser. In case the company chooses not to exercises its right, the successor in interest to the owner (whether an estate, bankruptcy trustee, or otherwise) will receive only the economic right (to receive distributions of the profits) unless and until a majority of other owners vote to admit the transferee as a fully substituted member (meaning the transferee will receive economic value, but will not be able to vote or otherwise participate in the management of the company).
- Co-Terminus Provisions - it may be prudent to provide that termination of rights as a shareholder or member also terminates the rights as an officer, director or manager as the case may be. Frequently, these provisions specify that the terms of any employment or similar agreement that are not dependent upon share or membership ownership are not affected by the sale or transfer.
- Dissolution - consideration needs to be given to whether or not the owners of the entity should agree that the entity cannot be dissolved except by a certain percentage of votes and that otherwise, shareholders and members waive any right to seek dissolution.
The list above is far from being inclusive. It is just a demonstration of the key issues that should be discussed, agreed upon and put in writing before distribution of the company interest. Since the owners of the company may change or human memory may deteriorate during the life cycle of the business it is vitally important to have a good written, all-inclusive, specific and non-ambiguous LLC Operating Agreement, which will serve as guidance and help to avoid disputes later on. Entrepreneurs should obtain appropriate legal advice from an experienced business attorney before getting into a business with other parties.
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