Often, business owners will come to me with questions or concerns about their Limited Liability Company (LLC). When I ask for a copy of their Operating Agreement, I’m often met with a blank stare or an embarrassed “We don’t have one of those.” I then have to explain that the question or concern they have about their LLC could have (or should have) been addressed in their Operating Agreement.
In an LLC, the Operating Agreement is the document that sets forth how the company operates, and more importantly, it governs the relationship between the owners. Many business owners (and unfortunately some professionals as well) mistakenly believe that the formation of the LLC is complete once the Articles of Organization have been accepted by the Ohio Secretary of State. The truth is, however, that the creation of the Operating Agreement is a critical step in the formation of an LLC. (For more on the steps in forming an Ohio LLC, read “Forming an Ohio LLC.”)
In the Operating Agreement, the owners can agree on critical issues such as:
Ownership of the Interests in the LLC
The Articles of Organization say nothing about who the members (owners) of the LLC are. This must be done in the Operating Agreement, where the members and their respective ownership percentages are set forth. Without having this information in the Operating Agreement, if there is a dispute later proving ownership could be very difficult. The result would be very expensive and time-consuming litigation.
Do you want each member to have an equal vote, or should voting be based on each member’s percentage of ownership. Will certain decisions require unanimous consent of all owners, or is a majority of owners enough? For example, assume you have 3 members in your LLC. Owner 1 has a 35% membership interest, Owner 2 has a 10% interest, and Owner 3 has a 55% interest. Here are just some of the ways the control of the company can be affected:
- If each member has an equal vote, then Owner 2’s vote (10%) has the same weight as Owner #3’s vote (55%).
- If votes are counted according to a majority of membership interests, then Owner 3, with 55% of the company, can always control what the LLC does.
- If some decisions must be unanimous, then Owner 2 can block any action of the company (overruling the owners of 90% of the company).
Of course, in most LLC’s the control desired will depend on the particular issue. For example, for the purchase of real estate or the admission of a new member to the LLC, the members may want to require the unanimous consent of all members, but for the more routine decisions, they may prefer a majority vote of the members, and for other issues they may decide to have a majority of the membership interests.
All of these issues can and should be set out in advance in the Operating Agreement.
Members or Managers?
Under Ohio law, an LLC is managed by the members (any member has the authority to bind the company in contracts and other activities). An LLC could elect (in the Operating Agreement) to be managed by Managers instead. For many business owners, it is advisable to have a “manager-managed” LLC, so that more control is retained.
With a “member managed” LLC, any member of the LLC can bind the company in any contract. During the time that the initial members are owners, that may be perfectly fine. However, over time new members may be admitted to the LLC, and you may not want them to have that power.
In a “Manager-managed” LLC, the members elect a manager or managers to run the company. They will generally appoint themselves as the manager, which allows them to retain control over the management decisions of the LLC. If new members are admitted to the company, they could be appointed as new managers as well, or the management could remain only with the original managers.
Transfer of Interests
What happens if a member dies or retires? The Operating Agreement can and should provide the rules for how and when a Member’s interest can be transferred (either to another Member, or to a member’s family member, or to a third party purchaser).
In many LLC’s, the owners of the LLC would prefer to control who they are in business with. They want to control how the members are allowed to transfer their interests. Being in a small business often means working closely together, and the participation of each member can be critical to the success of the business. Owners want to make sure that the people who are their co-owners are people who have the right skills and abilities, the right work ethic, and the right personality to be a contributing member of the company.
For example, you may be perfectly happy being in business with your current co-owner, but would not want to be in business with that person’s spouse. In that case, you would want to put restrictions in the LLC Operating Agreement that did not allow the transfer of interest to a member’s spouse. Similarly, you could restrict the transfer to a third party purchaser of a member’s interest.
These are only the beginning of the issues to be addressed in your Operating Agreement. If you have questions or would like more information about the creation, operation or use of an LLC to protect your assets, call us at (419-872-7670). We don’t charge for answering your basic questions on LLCs.