The Operating Agreement - The Missing Link in Too Many LLCs

The Limited Liability Company (LLC) has quickly become the most popular entity choice for new businesses. According to the Wisconsin Department of Financial Institutions, of the 38,869 domestic businesses newly formed in 2016, 34,067 (nearly 88%) were LLCs. Among the primary reasons for the popularity of the LLC are the lack of formalities required to form and operate an LLC. An LLC can be formed online with a few simple clicks and keystrokes by anyone with an internet connection. Unfortunately, far too many businesses stop there (often out of the desire to save a buck) and fail to take the necessary steps of drafting an Operating Agreement that sets out the relationship between the owners of the LLC.

The Operating Agreement is the document entered into by the members of the LLC that provides the terms of the members’ agreement relating to the operation of the LLC. The Operating Agreement is to your LLC what a prenuptial agreement is to your marriage. Everyone expects the best at the onset of the relationship, but problems will invariably come up. It is not fun to assume the worst, but protecting yourself and your company is simply smart business. While the Articles of Organization filed with the state create the liability protection between the members and the public, the Operating Agreement protects the members from each other.

Although there are a few statutorily mandated rules with regard to operation of the LLC, the LLC is largely a “creature of contract.” If the members do not enter into an Operating Agreement, or if the Operating Agreement is silent as to any issue, the members are at the mercy of the Wisconsin LLC statute. In other words, if your Operating Agreement does not cover a specific topic (or if you do not have an Operating Agreement), you are stuck with whatever state law says. I have yet to meet a business owner who believes the state knows best when it comes to operating their business.

Members typically alter the statutory default rules regarding admission of members, capital contributions, distributions, allocation of profit, management, and ability to transfer ownership interest. There are hosts of topics that are nowhere to be found in LLC statutes that still need to be addressed in an Operating Agreement. The provisions of an Operating Agreement are limited by not much more than the members’ creativity.

A small sample of the questions to be carefully answered in an Operating Agreement include:

1. Contributions: How do the members intend to value different kinds of contributions to the LLC? Does a member with key talents but little capital receive the same membership interest as the member who contributes significant start-up capital?
2. Distributions: Are distributions to be allocated based on the members’ capital contributions or their membership interests?
3. Governance: How will important decisions be made in the LLC? By vote? By a manager? By a combination? Are all members entitled to vote or are there different classes of members?
4. Transfer Restrictions: Can a member sell his/her shares to a third party? Do the other members get a right of first refusal? What happens if a member dies? What happens in the event of a divorce? If a member is able to sell, how much are his/her units worth?

Dilemmas like those presented by the above-referenced questions are thoroughly addressed in a well-drafted Operating Agreement.A primary goal of the Operating Agreement should be to foreshadow issues associated with the ownership of the LLC and spell out the method in which said issues are addressed.Wisconsin law requires that an Operating Agreement be in writing, and, like any good contract, it is best to have the Operating Agreement in place prior to the time a dispute arises.If the members of the LLC contractually agree on how the business is to be operated, disputes are less likely to cause turmoil among the members when issues arise.

In Wisconsin, there are no requirements for formalities of an Operating Agreement other than that it be in writing.A canned Operating Agreement form should not be used unless it has been subjected to close scrutiny, particularly with respect to its effect on the Wisconsin LLC statutes and tax codes.A “one-size-fits-all” Operating Agreement does not exist and any contrary assertion is questionable.

Business owners presumably form their LLC with the intent of doing things the “right way.”They know that they want to shield personal liability and add credence to their business.What they often do not know is that forming the LLC online is just the first step to ensuring that the LLC continues to provide the benefits intended.Engaging experienced counsel to draft, review or revise your Operating Agreement on a regular basis is good practice.Many law firms will create a LLC from start to finish (including the draft of the Operating Agreement) for a nominal flat fee.The risks of failing to enter into a well-drafted Operating Agreement can far outweigh the insignificant costs associated with its professional creation.

More information on creating an individualized operating agreement can be obtained from our experienced Business Finance, Formation & Restructuring attorneys.

Written By:
Attorney Steven J. Krueger