Limited liability company forms, including LLC operating agreement
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FORMING A LIMITED LIABILITY COMPANY |
Forming a limited liability company involves three steps:
- Articles of organization must be filed in order to create a legal entity;
- Capital must be contributed to the LLC by its members in order to provide it with the means to run a business; and
- An operating agreement dealing with the way the LLC will function and be managed must be signed by the members.
ARTICLES OF ORGANIZATION
The legal existence of an LLC begins when articles of organization are filed with the secretary of state or other designated official of the state in which the LLC is being formed. A business that has not filed articles of organization is treated as a sole proprietorship or partnership, and its owners do not enjoy limited liability protection.
Articles of organization provide information to persons who deal with an LLC about its existence, those who have authority to act for it, and how to serve it with process in a lawsuit. Although we offer a generic form of articles of organization, it’s generally best to use the official form published by the state agency responsible for LLC filings in the state in which an LLC is to be created if one is available. These forms are free and serve as a convenient checklist of the information that a particular state requires in articles of organization.
A cautionary note: It is generally inadvisable to take advantage of the blank on an official form that allows additional provisions to be inserted. Articles of organization are a matter of public record and can only be changed by filing articles of amendment with the state. The LLC’s operating agreement is a better place to deal with additional matters because this document is not available to creditors and competitors and can be amended by agreement of the LLC’s members.
Most information included in articles of organization is routine. But articles indicate whether an LLC will be managed by its members or by managers.
Most small businesses are managed by their members. All members have the right to participate in decisions about the operation of the LLC and the authority to act on its behalf in the ordinary course of business. This is similar to a general partnership and gives members the greatest possible role in the affairs of the LLC.
But management by one or more managers, who often don’t need to be members of the LLC, can be a better choice in three situations:
- The LLC has a large number of members making decentralized decision-making cumbersome and creating a risk that members might take actions on behalf of the LLC that are inconsistent with the wishes of the other members.
- Some members participate actively in the business of the LLC, and others are investors who don’t want to take the time to keep up on LLC affairs needed to participate in its day-to-day management.
- There is only one member of the LLC, the member is an entity such as an LLC or corporation, and a representative of the member will be appointed to act on the LLC’s behalf.
CAPITAL CONTRIBUTIONS
The money, equipment, furniture, fixtures, and other assets necessary to conduct an LLC's business must be contributed by its members. An LLC can borrow, lease, or license these assets, but if a substantial number are acquired in this manner, the LLC may be undercapitalized, which will expose its members to the risk of losing their limited liability under the piercing the corporate veil doctrine.
Members should transfer title to assets to the LLC, not just possession of them, and cash contributions should be deposited in the LLC's own bank account. Otherwise, if the LLC’s business fails to become profitable, assets held by the LLC will be subject to claims of its creditors, and this may cause the loss to fall unfairly on members who have transferred them. In addition, a failure to transfer title to assets may leave the LLC undercapitalized, exposing its members to the possible loss of their limited liability.
OPERATING AGREEMENT
An LLC's operating agreement serves five important functions:
- It provides a record that the LLC was properly organized and adequately capitalized.
- It allows the members of the LLC to write their own rules of operation by modifying statutory default rules.
- It provides members and managers with a roadmap for operating the LLC in accordance with legal requirements.
- It helps smooth the way through disruptive events like the death or disability of a member and protects the integrity of the LLC's ownership by limiting transfers of interests.
- It fulfills a prerequisite to the LLC's opening a bank account.
A record of the LLC’s organization and capitalization helps avoid the possibility that the members will fail to obtain limited liability protections. It also ensures that members understand and meet their obligations to contribute capital to the LLC.
The law of the state in which an LLC is created contains statutory rules that control LLC operations if the operating agreement fails to do so. The rules vary from state to state but, among other things, deal with the division of profits and losses between members and their voting rights. The statutory rules are often inconsistent with the wishes of an LLC’s members, and addressing these matters in an LLC’s operating agreement avoids unexpected and undesirable results.
LCCs are not subject to the rigid rules applicable to corporations, and there is a good deal of flexibility in designing their management structure. But all members need to understand the rules of the game in order to work together efficiently and effectively. These rules are set forth in an LLC’s operating agreement.
The death or retirement of a member can adversely affect an LLC’s business, particularly if the member participated actively in the operation of the business. Most times, the other members want to pay a fair price for the interest of a dissociated member—any one of them could be the affected member. But the other members don’t want the terms of payment unduly burdensome. The operating agreement is the place where the members can agree in advance what a dissociated member will be paid and on what terms. If the matter is left to the controlling statute, it’s possible that the member’s interest would not only have to be paid in cash but the price might be determined by a court in a proceeding that could be time-consuming and expensive. In some instances, the controlling statute may deny the dissociated member the right to any payment until the LLC dissolves.
Members of a closely-held LLC are generally concerned about preserving the integrity of the ownership-management group and preventing third parties who may not share their goals for the LLC’s business to acquire a member’s interest. State LLC statutes make such interests freely transferrable, so it’s important that the operating agreement give the LLC or the other members a right of first refusal to purchase an interest that a member intends to transfer.
Even LLCs with only one member need an operating agreement. It can’t open a bank account without one. Moreover, while statutory default rules are of little concern if one member has the authority to make all decisions in the management of the LLC’s business, an operating agreement serves the other three functions listed above.
Alberty Publishing offers a number of operating agreement forms, which are designed for use in different situations. This helps the drafter ensure that a form used for a particular LLC contains all the provisions it needs. It also allows the operating agreement to be no longer or more complicated than it needs to be.
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