What is an Operating Agreement of the LLC?
What is an Operating Agreement for LLCs?
Operating Agreements are a relatively new concept for many clients in Wilmington, NC. Even those who have been doing business in other states such as California, Pennsylvania or Virginia for years have only a peripheral knowledge of what an Operating Agreement is and why they are necessary.
Operating Agreements were created by the Limited Liability Company Act of 1993. In the context of a Limited Liability Company, the Operating Agreement is to an LLC what the Bylaws are to a corporation: a written document that outlines the management group members, their responsibilities, and how the LLC will conduct its business. In simpler terms, it is the set of "operating instructions" for your LLC .
One of the key advantages of the Operating Agreement is that it gives each member of the LLC a greater level of control over the management and direction of the company. This is particularly important in the State of North Carolina, where the default management structure is "members managing members". In other words, unless modified by the Operating Agreement, the default management structure is that the managers are the actual members of the LLC – aka the owners – themselves. This means that each member of the LLC has voting and operational responsibilities within the LLC. If you don’t want to be responsible for making LLC decisions, then the Operating Agreement should set out a different management structure.
Importance of Operating Agreements in North Carolina
Why Even If LLCs In NC Are Not Required To Have Operating Agreements, They Should Have One
Here are some of the more frequent reasons why LLCs in North Carolina focus on having an operating agreement:
Provides Liability Protection. It provides the owners with liability protection because it helps to establish that the owners did not pay themselves too much money (or take too many distributions) especially when the business had debts or liabilities of any sort. Courts can pierce the corporate veil and hold the owners personally liable if it can be established that the owners took distributions from the company when the LLC or corporation was in debt as a means to pay themselves instead of paying the obligations owed. A carefully drafted operating agreement can help in the event that is ever challenged by a creditor.
Provides Clarity. It can provide clarity among the owners regarding their respective right to receive distributions and to participate in the affairs of the business.
Can Give Owners More Flexibility In Estate Planning. It can help with long-term estate planning because if written correctly it can allow owners flexibility and opportunities for opportunities for wealth transfers as part of their estate plan. For example, the operating agreement may include buy-sell provisions that trigger based upon age or health that create flexibility for families who own a business. In a prior post, I discussed some of those options on the DisputesOverBusiness.com Blog.
Provides a System of Dispute Resolution. It can also provide a system of dispute resolution within the business to try to resolve disputes that arise before involving the court system or arbitrator.
Provides For The Consensus Of The Owners. It will include provisions that the owners have discussed and thought through. Often, a dispute arises when the members seek to make decisions about their affairs and have never discussed the issue. Having those decisions written down can help resolve disputes.
Helps Maximize The Value Of The Business. Having an operating agreement can help increase the value of the business. In addition to the items discussed above, there are many other items which often are overlooked in terms of their value by owners until they see how it could improve the value of the business.
Key Ingredients of an NC LLC Operating Agreement
An LLC operating agreement typically includes sections on the formation and purpose of the business, capital contributions, ownership interests and ownership percentages, and the management structure.
Formation and Purpose
In the opening section of an LLC operating agreement, you’ll often see information about when the company was formed, where it’s located, true business name, and the primary purpose behind the business’ formation, including any special enumerations to be followed in carrying out business operations, such as environmental policies, employment policies, and so on.
Capital Contributions
Along with identifying ownership interests, an LLC operating agreement will also list each member’s "capital contributions," which is essentially the whole reason you’re forming the company in the first place. It goes without saying that these contributions can be in a variety of forms, including cash, intellectual property, equity interests in another company, etc.
Ownership Interests and Percentages
It’s important to remember that while an LLC will have several members, they may not all act as equal owners. Each member will likely own a different percentage of the company based on their contribution, investment or other factors, and as such, their rights should be evaluated based on their percentage. Ownership interests and ownership percentages will serve as a primary factor in profit and loss distribution, too.
Management Structure
While some LLCs are member managed, meaning all members conduct business for the LLC and make important business decisions, others appoint managers to handle day-to-day business activities. An LLC operating agreement will outline how the company will choose to be managed.
For example, a member managed LLC will state that the members will elect officers to carry out the goals of the company, and how elections should occur (who’s eligible, how many votes are needed, etc.). By contrast, managers of a manager managed LLC are appointed by the members of the company. The LLC operating agreement will state the powers of the managers, the duration of their service, and any other important details about their appointment or function.
Tips for the Operating Agreement
When it comes to drafting an operating agreement for your North Carolina LLC, specificity is key. A comprehensive operating agreement should be a "living" document, one that can evolve as your business does over time. It should be tailored to meet the specific needs of the parties involved, and to adequately address concerns that are unique to their state. The following tips can help ensure that your operating agreement meets the unique needs of an LLC.
Avoid using a generic template to draft an LLC operating agreement. There are multiple variations of LLC operating agreements, and if you have a general, one-size-fits-all template, it will likely not contain all of the elements necessary to a comprehensive operating agreement.
Customize your operating agreement to fit the needs of the LLC . Although there is no one-size-fits-all operating agreement, even when it comes to North Carolina, there are certain elements that every operating agreement should contain. Members should also work with an attorney to draft an operating agreement that adequately addresses their needs, rules and obligations. Some of the elements that should be considered include: capital contributions, distributions, voting rights and duties.
Be as specific as possible. Practically every operating agreement will have at least one provision that is ambiguous, that leaves at least one question unanswered. The broader the language used in an operating agreement, the more likely it is to leave a large gray area. As such, be as specific as possible to avoid confusion and misunderstandings later on.
Legal Considerations and Flexibility of NC Operating Agreements
In terms of legal requirements under the N.C. Limited Liability Company Act, there are no specific requirements for an operating agreement: North Carolina is a "default" state in that a member can form an LLC without any operating agreement. Simply by filing Articles of Organization with the Secretary of State, an LLC is formed. However, most new members will have an operating agreement, whether it be formed in part or in whole separately from the Articles of Organization or by incorporating the terms and conditions into the Articles of Organization itself. However, if the LLC is formed without an operating agreement, then the statutory provisions of North Carolina’s LLC Act govern the management and operation of the LLC (so long as the provisions of that act are not altered or limited by an operating agreement). Therefore, in the event of a dispute, the operating agreement and the default statutory provisions of North Carolina’s LLC act would each need to be reviewed to determine the rights and obligations of each member.
Likewise, there are very few restrictions on the types of businesses to be conducted through an LLC, or how management is to be conducted. However, any business activity can be formed under an LLC, and the management of that LLC can be altered or scheduled under an operating agreement, so long as such alteration or scheduling does not contradict the default state provisions of the LLC Act. Also, unless otherwise provided for in an LLC’s operating agreement, if an LLC has more than one member, each member shall be considered to hold the same voting power as the number of percentage points it holds in the LLC at the time of voting, giving a member with greater ownership more say in normal day-to-day operations.
Enforcing and Amending Operating Agreements
The operating agreement of an LLC in North Carolina is enforced like any other contract. If the terms of the agreement are not met, it is possible to file suit to enforce the terms, especially if there are damages incurred as a result of the breach. If a member does not follow the terms of the operating agreement, those who feel wronged can ask for injunctive relief. For example, if a member is not casting votes for distributions of earnings in accordance with the operating agreement, then others who are hurt by that decision can file a suit to reverse the action taken. This is true even if that member was acting in good faith when absent from the voting process. Shareholder derivative lawsuits are also possible if a director is breaching his or her fiduciary duties , in which case all members can have the option to participate in the lawsuit. Suppose odds are split on an important vote, but two of the directors will be out of town. They can use this situation to their advantage and cast votes for future events in their favor—unless the operating agreement has rules in place to counteract them. Having clear terms in the operating agreement will help to prevent this type of problem. If something needs to be changed in an operating agreement, an amendment can be made if all members agree to it. An amendment can include new procedures, a relocation of the office, or the addition of new members. It can also be used to change terms that are no longer relevant to the business.
