The limited liability company (LLC) is often applauded for its flexibility in giving its members the freedom to decide how they want to govern their operations and share their management and financial rights.
But to truly take advantage of this freedom, the members should have a good written operating agreement that sets forth how they want to govern the operations and that specifies the members’ rights and responsibilities. If they don’t have an operating agreement, they will be governed by the default provisions of the LLC law of their state of formation. In that case, the members will be relying on the state legislators to know what they want and what provisions will meet their specific needs – which can often result in the exact opposite happening.
In this article, we will explore why it’s so important for every LLC to have an operating agreement, rather than relying on the default provisions.
What is an operating agreement?
Most states require only minimal information, such as the name of the company and its registered agent, on the articles of organization. The details regarding the structure and operation of the LLC are intended to be left to the members. Ideally, the members adopt a written operating agreement that is drafted to meet their specific needs, desires, and understandings. This agreement, which is binding upon the members once it is signed, should specify:
- How the LLC will be managed —by its members or by managers (who may or may not be members)
- How the management team will be selected
- How key business decisions will be made
- What actions require a vote by the members (and what percentage is required for approval)
- What are the duties and responsibilities of the members
- How are profits and losses allocated among the members
- How distributions are allocated among the members
- The members’ rights to sell their ownership interest
- The requirements for adding new members
- What triggers the disassociation of a member
- The members’ right to leave the LLC and whether the LLC must buy them out
- What events will trigger dissolution of the company
What happens if the LLC has no operating agreement?
Every state has provisions governing limited liability companies. A number of states have adopted the Revised Uniform Limited Liability Company Act or its predecessor the Uniform Limited Liability Act, or the ABA’s Prototype LLC Act, although each state has its own peculiarities. Even if the members don’t relish wading through the nuances of the state statutes, every member must know one critical fact: state statutes establish the default provisions for an LLC.
The state statutes have provisions governing most, if not all, of the issues we listed above that members should provide for in their written operating agreement. The default provisions are intentionally general, and represent the legislators’ best guess as to how the members of their state’s LLCs would want to govern the LLC’s internal affairs and share their rights and responsibilities. While some, or even most of these provisions may be exactly what the members of an LLC want, the likelihood of every single default provision being what the members had in mind are far less likely. And if there is no operating agreement then every single default provision governs the LLC and its members.
Default rules on how the LLC is managed
As an example, consider the LLC’s management structure. In most states, the default form of management is “member-managed,” which means all the members must agree on all the business decisions. It also means that all members have the authority to bind the LLC by entering into contracts with third parties. If the members do not want to share management equally (say the member who contributed more gets more of a say), or only want certain members to have authority to enter into contracts or otherwise bind the LLC, this must be set forth in the operating agreement or the default rule governs.
If the LLC wants to be managed by managers instead of all the members, in many states this must be set forth in the operating agreement or the default rule of member-management governs. (In some states manager-management has to be provided for in the articles of organization).
There may also be default rules on the members’ standard of care, rules for meetings, the vote required to make ordinary business decisions and extraordinary decisions like mergers and dissolutions, and more. These default provisions may or may not meet the members’ specific needs. Only by addressing these issues in the operating agreement can the members ensure that the company is managed the way the members wish it to be managed.
Default rules on how the members’ financial rights are allocated
The LLC statutes also have default rules that will govern how the members share their financial rights. For example, in many states, the default rule is that members share distributions of income equally. But it is not unusual for members to want, instead, to share based on capital contributions. If there is no operating agreement, distributions have to be shared equally. Many states also have default rules on the sharing of profits and losses. Again, that default rule may or may not reflect what the members want.
Other default rules to be aware of
The statutes also generally have a default rule requiring unanimous consent to add a new member and the unanimous consent of non-selling members before a member can sell his or her entire membership interest to a third party. This is fine for many LLCs. But there are also LLCs that want to expand and be able to add new investors without needing all of the members to consent.
In addition, in some LLCs, members do not want to be locked into their investment and want to be able to sell without the approval of all the other members. In other words, different LLCs have different needs and the default rules do not, and cannot, account for that.
What about single-member LLCs?
Although having an operating agreement rather than relying on the default provisions is particularly important for multi-member LLCs, a single-member LLC should have a written operating agreement as well. There are default provisions that will govern single-member LLCs that the member may want to avoid.
For example, in many states, the default rule is that an LLC must dissolve at a time it has no members. If the member, for example, wants a child to take over upon his or her death rather than the LLC dissolving, that would have to be provided for in an operating agreement. Or the member may not want to manage the LLC. If that’s the case, the member may have to provide in the operating agreement that the LLC will be manager-managed to avoid a member-management default rule.
Statutes are amended and default rules change
Another reason why it’s advisable that every LLC have a written operating agreement rather than relying on default rules is that the states amend their LLC laws and default rules can change. Many LLC laws were enacted around 25-30 years ago and are now being updated. In fact, every year at least one state seems to be repealing its LLC law and enacting a whole new LLC statute. And when LLC laws are amended, that can mean that a default rule that the members were happy to be governed by when the LLC was formed may not be the default rule governing them today.
Here's one example of a change some states have recently made. Many early LLC acts gave members the right to withdraw from the LLC and require the LLC to pay the members the fair value of their LLC membership interest.
However, experience showed that many LLCs could not afford to buy out members when they wanted to leave. As a result, some states changed the default rule to provide that a withdrawing (or disassociating) member is only entitled to the rights of an assignee, and the LLC is not required to buy them out. Members of an LLC without an operating agreement delineating their rights upon leaving the LLC, in states that changed this default rule, may be in for quite a shock if they think they still can make the LLC purchase their interest.
Stay on top of law changes by proactively reviewing your operating agreement
The only way to guarantee that an LLC functions as the members want is to adopt an operating agreement that covers all the essential areas, from management to financial and beyond. The operating agreement should also be reviewed on an annual basis to ensure that it still reflects the members’ wishes and addresses all areas where the members want to override the default provisions of state law. It may be advisable to consult with an attorney who is well-versed in the state law that governs the LLC because subtle changes that a layperson might overlook can have a significant impact on the company’s operations and the members’ responsibilities.