Common Operating Agreement Clauses You Shouldn’t Skip

Forming a limited liability company (LLC) requires more than just filing paperwork with its home state. While most states don’t need you to file an operating agreement with them, having one is crucial for protecting your business and its members.

An LLC’s operating agreement outlines the rules and procedures that govern your company’s operations. Both are specified in clauses that can be modified to your venture’s changing needs. Without these provisions, your business could face legal and operational challenges.

In this article, we discuss some of the most important clauses to include in your LLC’s operating agreement.

Key Takeaways

• LLC operating agreements must have clauses focusing on areas such as the company’s management structure, profit distributions, and dissolution procedures.
• Provisions related to management structure and voting rights prevent disputes while fostering strategic decision-making.
• Partnership terms addressing capital contributions and withdrawal procedures protect the LLC’s financial stability.
• Clauses covering profit and loss distributions ensure that all LLC members receive a fair share of corporate profits.
• Other essential provisions to include in your LLC operating agreement include those regarding member exits and transfers, dispute resolution, and potential amendments.

Management Structure & Voting Rights

LLC operating agreements must define the venture’s management structure and the voting rights given to each member.

Member-Managed vs. Manager-Managed

Your operating agreement should specify whether your LLC is member-managed or manager-managed. The business’s designation affects everything from daily operations to tax obligations.

In a member-managed LLC, all members handle daily operations and vote to approve or oppose business decisions. This structure works well for smaller LLCs where all members are actively involved. In manager-managed LLCs, specific individuals handle operations while other members serve as passive investors.

More importantly, your operating agreement should state:

• Who has the authority to make binding decisions
• Which decisions require member votes and manager approval
• How your LLC appoints and removes managers
• What the business can control (e.g., compliance, employee management)

Voting Rights & Procedures

Voting rights allow LLC members to make crucial decisions that impact business operations. As you write your operating agreement, make sure to write provisions discussing voting thresholds for different types of decisions. The table below lists the most common ones for LLCs.

Additionally, clauses related to decision-making should describe how your LLC conducts meetings, notifies members, and takes votes. Consider including provisions for electronic voting and remote participation, especially if members live outside of the LLC’s home state.

Capital Contributions & Ownership Percentages

When it comes to an LLC member’s capital contributions, your operating agreement must outline provisions related to them. That’s because the amount of a member’s initial and ongoing capital contributions affect their ownership interest and profit distribution rights.

Clauses describing capital contributions protect all LLC members by establishing their financial obligations and shares of business ownership.

Initial Capital Requirements

To start, specify the type and value of each member’s initial capital contribution. If a member’s property has been transferred to the LLC and professionally appraised, include important details of its valuation in the operating agreement. Conversely, specific services performed by LLC members must come with the appropriate value and clear expectations set for them.

Other essential provisions regarding initial capital contributions include:

• Deadlines for making initial contributions
• Consequences for failing to meet contribution requirements
• Procedures for additional capital calls

Additional Capital Contributions

Over time, most LLCs would need additional capital for growth, equipment purchases, or operational needs. Your operating agreement should establish procedures for additional capital calls, including:

• Voting requirements for authorizing capital calls
• Member rights to make additional contributions or not
• Consequences for members who cannot or will not contribute
• The effects of dilution on ownership percentages

Profit & Loss Distribution Processes

How your LLC distributes profits and allocates losses can affect the relationships between its members and their tax obligations. Its operating agreement must include detailed distribution clauses that meet member expectations and taxation requirements.

Profit Distribution Methods

Based on your LLC’s business model and members’ preferences, an operating agreement can direct the venture to make any of the following distributions.

Pro-Rata Distributions

Pro-rata distributions allocate your LLC’s profits and losses in proportion to each member’s share, stake, or entitlement. This way, each individual gets a fair share of the company’s profits and losses based on their ownership interest or contribution.

Preferred Return Distributions

In preferred return distributions, your LLC would give certain members their share of profits before paying others. The process continues until your business reaches an established rate of return on the initial investment. Preferred return distributions give investors some degree of comfort and predictability.

Other Common Methods

Single-member LLC owners pay themselves through “owner’s draws.” In this distribution method, the LLC member takes some of the business’s profits.

Other LLCs make guaranteed payments to their members. It’s usually done when LLC members perform services regardless of whether the business generates profits or not.

Tax Distribution Requirements

Tax distributions are payments made by businesses, including LLCs, to its owners or shareholders to cover their tax liability. Pass-through business entities usually use these distributions.

For tax distributions, make sure to draft provisions that require your LLC to distribute enough cash to cover each member’s tax obligations on their allocated share of business income. Your operating agreement should specify terms related to the following:

• When tax distributions should be made
• How each LLC member’s tax liability is calculated
• When tax distributions are prioritized over other distributions
• What to do when tax distributions can’t be fully covered by cash

Member Exit & Transfer Procedures

LLC members can leave the business at any time. However, their exits can disrupt your operations without proper procedures in place. Your operating agreement must include clear terms about member exits and ownership transfer restrictions.

Voluntary Exits

Establish clear procedures for members who want to leave the LLC, including required notice periods and non-compete agreements. You can also specify valuation methods for determining the departing member’s interest and payment terms for potential buyouts.

Involuntary Exits

Sometimes, LLC members must be removed due to misconduct, incapacity, or breach of agreement. Your operating agreement should specify grounds for a member’s involuntary termination and the voting procedures for this decision.

• Due process procedures protecting member rights
• Valuation adjustments for involuntary departures

Also, consider including clauses that ensure due process to protect member rights and cover valuation adjustments for involuntary exits.

Transfer Restrictions

Your LLC may also want to restrict ownership transfers through methods such as right of first refusal and buy-sell agreements. The former gives the remaining members priority to acquire a departing member’s interests.

Overall, transfer restrictions are important for staying compliant when your LLC has multiple members.

Procedures for Resolving Disputes

Even the most harmonious business relationships can face conflicts. Comprehensive dispute resolution clauses in your LLC operating agreement can help you handle disagreements without undergoing costly litigation.

Mediation Requirements

Mandatory mediation clauses require members to try to resolve disputes with a third party involved before pursuing other remedies. Mediation offers advantages such as lower costs than litigation, faster resolution, and maintaining business relationships.

Mediation-related provisions in an operating agreement can cover areas such as the disputes that can be mediated and how mediators are chosen.

Arbitration Provisions

Arbitration can also be conducted if mediation can’t resolve disputes. Operating agreement clauses related to this process should address:

• How arbitrators are chosen
• Which rules apply to arbitration proceedings (AAA, JAMS, etc.)
• What the discovery phase can cover
• How arbitration awards will be given

Clauses for Resolving Deadlocks

If you run a multi-member LLC, you may encounter deadlocks during voting. Make sure to include mechanisms that resolve deadlocks in your operating agreement, including those for tiebreakers.

Dissolution & Liquidation Procedures

While nobody starts an LLC expecting it to fail, including dissolution and liquidation clauses protects all members if the business is unable to continue operations. These provisions should address potential dissolution or liquidation.

Grounds for Dissolution

Dissolution-related clauses must specify causes or grounds for dissolution, including a majority vote and expired terms. LLCs may also be dissolved if they find it difficult to continue their operations or it’s ordered by legal judgments or requirements.

Liquidation Procedures

Your operating agreement should also detail procedures for liquidation. They may cover the designation of liquidators, sale of assets, settlement of financial obligations, and distribution of any remaining assets to members.

Finally, your operating agreement should specify the order of distributions made during liquidation. At most, it can involve:

1. Creditor payments and business expenses
2. Member loans and advances
3. Return of capital contributions
4. Remaining assets distributed per ownership percentages

Fiduciary Duties & Member Obligations

Your operating agreement should clearly define the duties and obligations of members and managers to prevent conflicts of interest and establish accountability standards.

Duty of Loyalty

Members and managers owe fiduciary duties to the LLC and other members. Hence, your agreement should have clauses addressing these duties. They can include restrictions on competing businesses, disclosing conflicts of interest, and limitations on personal use of the LLC’s operations.

Duty of Care

The duty of care is another area that operating agreements must tackle. Specific clauses can become guidelines for decision-making, documentation, limited liability, and other important aspects related to an LLC member’s duty of care.

Non-Compete & Confidentiality

Your LLC’s operating agreement can also protect its competitive advantages through:

• Non-compete clauses preventing members from engaging in competing businesses
• Non-disclosure agreements protecting confidential information and trade secrets
• Non-solicitation provisions restricting the recruitment of employees or customers
• Return requirements for departing members with company property

Amendments & Governance

As your business changes, you may need to update important information about it. Adding clear amendment procedures to your operating agreement ensures changes can be made efficiently while protecting member interests.

Amendment Requirements

LLC amendments, like updating the company’s address or members, need to be voted on. You can use the voting thresholds we’ve mentioned earlier for amendments. For example, the business would need unanimous member consent for operating agreement revisions.

Record Keeping & Reporting

Finally, consider including clauses for proper record-keeping and providing information to members. These provisions may tackle:

• Annual financial reporting and tax document distribution
• Meeting minutes and voting record maintenance
• Member access to specific LLC records
• Communication procedures for important business developments

Frequently Asked Questions

What happens if my LLC doesn’t have an operating agreement in place?

If your LLC doesn’t have an operating agreement in place, state laws will govern it. This scenario may not align with the company’s operational needs or the members’ expectations.

Generally, state laws ensure equal management rights and profit sharing, regardless of whether capital contributions are made. As a result, your business may face conflicts and lose operational flexibility.

Can I revise my LLC’s operating agreement after formation?

Yes, you can revise your LLC’s operating agreement after formation. If the original document specifies amendment procedures for operating agreements, make sure to follow them.

In addition, most amendments to your operating agreement require member approval. A full revision of the document requires unanimous member consent.

How detailed should voting procedures be?

Voting procedures should be detailed enough to prevent disputes and ensure efficient decision-making. Clauses regarding these procedures must cover important areas such as notifying members, establishing quorum, and using specific voting thresholds.

Why should I include dispute resolution clauses in an operating agreement?

You should include dispute resolution clauses in an operating agreement because they specify how conflicts should be resolved without undergoing litigation.

These provisions typically focus on mediation and arbitration. Having them in your LLC’s operating agreement can help you avoid costly litigation, protect business relationships, and conduct business as usual.

Can an operating agreement keep LLC members from transferring ownership?

Yes, an operating agreement can keep LLC members from transferring ownership.

Transfer restrictions, such as right of first refusal or member approval requirements, can be included in this document to prevent third parties from receiving ownership interests. These clauses keep the LLC in control and ensure that its ownership changes with member approval.

When should an LLC review & update its operating agreement?

For the most part, an LLC should review its operating agreement regularly. The document can be updated after significant changes are made to the business’s basic information or operations. Examples of these include adding new members, receiving substantial capital contributions, or electing a specific tax classification.

What happens if LLC members fail to make capital contributions?

If LLC members fail to make capital contributions, the company must enforce the rules set by its operating agreement. The document should specify potential consequences for missed contributions, such as limited voting rights or financial penalties. With clear terms for this aspect of your LLC’s operations, you ensure its stability and reduce the risk of disputes among members.

What valuation methods are most effective for member buyouts?

The most effective valuation methods for member buyouts include professional appraisals. Such procedures determine the fair market value of a member’s assets.

Alternatively, your operating agreement can provide predetermined valuation formulas. It can even include multiple appraisal requirements for major business transactions.

Should operating agreements address a member’s potential disability?

Yes, operating agreements should address a member’s potential disability. Related provisions can include:

• Succession planning
• Buyouts made by disabled members
• Insurance requirements
• Decision-making when a member becomes incapable to do so

Work with NCH for LLC Succession Planning

How do capital contribution requirements affect new LLC members?

New LLC members must follow the capital contribution requirements specified in an operating agreement. When drafting your agreement, consider including clauses for minimum contributions and ownership interest calculations. These terms will help new members understand how much to contribute and what they need to do when making capital contributions.

Expert Tips From NCH

1. Include specific deadlines and consequences for all member obligations in your operating agreement. It encourages accountability and prevents delays that affect your LLC’s operations.
2. State protocols for open communication between members and proper documentation of all member votes and agreements in your operating agreement. These clauses can help your business avoid future disputes.
3. Establish tie-breaking mechanisms for potential voting deadlocks. Under your operating agreement, you can appoint a tiebreaking member, conduct mediation, or determine how to resolve deadlocks.
4. Consider “baseball arbitration” for member disputes. Each side proposes a settlement amount, and the arbitrator must choose the final award from these amounts.
5. Draft provisions for succession planning that address a member’s death, disability, or retirement. Set valuation methods for the individual’s ownership interest and detail whether it would be given to their heirs or beneficiaries.

Bonus Tip

Watch the short video below to know how important an operating agreement is to an LLC.

Create a Comprehensive LLC Operating Agreement

A comprehensive operating agreement with essential clauses allows your LLC to achieve long-term growth while protecting its members. All of the provisions we’ve covered must be included to help you manage business operations and prevent costly disputes.

When drafting your LLC operating agreement, have a trusted legal expert review it. NCH is ready to help you ensure that your agreement addresses all important areas and adheres to current legal requirements.

Contact Our Legal Experts Today

DISCLAIMER: The above material has been prepared for informational purposes only, containing opinions of the provider and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. Please consider consulting tax, legal, and accounting advisors before engaging in any transaction.