If you’re looking for an Operating Agreement for your limited liability company (LLC), you should steer clear of online businesses that offer documents at cut-rate prices or even for free. What looks like a good deal at first could spell disaster for your company.
Many LLC owners, who are called “Members,” don’t fully understand the importance of an Operating Agreement in protecting their best interests and intentions. Because the LLC form offers business and venture start-ups a large degree of flexibility in the areas of taxation and management, decisions on those topics should be carefully considered. A well-drafted LLC Operating Agreement will address many issues, among them whether the company will be managed by certain Members as managers, or by all Members; the degree to which Members or managers have the right to bind the LLC; what conditions should precede a distribution of profits; whether a Member should be permitted to vote by proxy; restrictions on Members transferring partial shares to third parties or leaving the LLC; “drag-along” and “tag-along” rights; “reverse-vesting” that can penalize a Member who leaves the LLC early; dispute resolution; and jurisdiction and venue where any lawsuit between Members, or by Members against the LLC, must be brought.
In order to protect Members adequately, these issues will need to be addressed in a nuanced manner, not as boilerplate. Many Operating Agreements available online, and many provided by law firms, merely regurgitate provisions from the applicable LLC statute that would apply in the absence of an Operating Agreement. (Every state has an LLC statute.) The value of an Operating Agreement, however, lies in defining the relationship between Members beyond (and in lieu of) the statutory “default” position. The issues mentioned above are rarely adequately addressed in statutes passed by lawmakers.
Recently, I went through the motions of creating an Operating Agreement via one online service provider (which I’ll refer to as “Cut-Rate”), and the result was a disaster. In the interactive process, Cut-Rate asked whether the LLC will be taxed as a partnership or a corporation — and you have to choose one, even though that choice does not need to be made in an Operating Agreement and should not be made without consulting an accountant. Cut-Rate then goes on to ask, “How will decisions be made by the Members?,” but it offers only two options that “apply to contract based decisions as well as other voting situations that are not contract based:”
– All decisions require a majority vote based on percent of ownership. (Note: If any Members have a majority ownership, they will be able to make the decisions without the input of the other Members); [OR]
– All Members will have an equal vote, regardless of percent of ownership, including contract decisions that may bind the LLC.
Neither of these options is necessarily desirable, but Cut-Rate fools you into thinking that there are no other possibilities. Nevertheless, Members may want to allow each Member to incur expenses under a certain amount, but require notice to, or even consent of, the other Members for larger expenditures or certain kinds of expenditures; or they may want some decisions to be subject to approval by a majority or a supermajority, and other decisions to be unanimous. The choices should be governed by factors such as how the Members see themselves as having, or sharing, decision-making power, the type of business the LLC will engage in, and what roles Members play in the business of the LLC. But Cut-Rate considers none of this.
Limited options are not the only problem with the Cut-Rate’s instant Operating Agreement. Although I chose “All Members will have an equal vote,” I was unpleasantly surprised to find the following provision, which could override any intention of the Members to have an equal say in important business decisions — for example, entering into a long-term lease or taking a bank loan:
Members as Agents. All Members are agents of the Company for the purpose of its business. An act of any Member, including the signing of an instrument in the Company’s name, binds the Company where the Member executed the act for apparently carrying on the Company’s business or business of the kind carried on by the Company in the ordinary course, unless the Member had no authority to act for the Company in the particular matter and the person with whom the Member was dealing knew or had notice that the Member lacked authority. An act of a Member binds the Company, however, even where the Member executed the act not apparently for carrying on the Company’s business or business of the kind carried on by the Company in the ordinary course only if the act was authorized by the other Members.
In the first long sentence of this paragraph, a Member’s act binds the LLC unless “the person with whom the Member was dealing knew or had notice that the Member lacked authority” — something that in most situations would never happen. (Think about it: if you’re going to enter into a binding contract, are you going to tell the other party, “oh, I don’t have authority to do this”?) The second sentence may or may not nullify the first sentence, depending on what the judge, jury, arbitrator or mediator thinks about it, but for my money, I don’t think so. Rather, it concerns a completely separate issue, i.e., where a Member acts outside the course of ordinary business. In that event, the provision states, the Member’s act is only binding on the LLC if the act was “authorized by the other Members.” Authorized how? By majority? By unanimous decision? Cut-Rate’s Operating Agreement doesn’t say.
Another glaring example of Cut-Rate’s inadequacy is the manner in which it deals with competition by non-managing Members with the business of the LLC. If you choose the managed-by-managers option, then a Member who isn’t a manager is not restricted from setting up or assisting a competing business, and owes no duty of good faith to the LLC or to other Members, even if that Member has access to the LLC’s confidential information, such as its business and marketing plans. For managers, Cut-Rate’s Operating Agreement creates a completely unnecessary “Board of Managers” and provides that Managers can engage in a competing business as long as a majority of the “Board” approves. However, this is exactly the kind of decision regarding which Members should want a unanimous vote by all Members, not just the managers. Unfortunately, Cut-Rate doesn’t offer that as an option.
Cute-Rate also falls down on the job in the area of dispute resolution. The Operating Agreement provides that “All Members” agree to enter into mediation before filing a lawsuit, but it’s not obligatory: if a Member doesn’t show up, then the parties can just file suit. If the parties do show up and they can’t resolve their dispute after one session, then they need to file suit to resolve the issue. These are bad options. Lawyers and businesspeople who have experience with LLCs will know that there is a range of possibilities for resolving stalemates, without having to resort to litigation, which can spell the death of the LLC.
Finally, Cut-Rate and other online document companies do their clients a disservice by not providing them with the basis for making even those limited decisions that are being offered. As I was reading through Cut-Rate’s cursory explanations, I thought to myself that few customers will understand the legal implications of what they are reading and that if they knew what decisions were being made for them, they would close their browsers and seek professional guidance.
At WebTM, we have ample experience in preparing Operating Agreements that meet our clients’ needs at a reasonable cost. We avoid legal jargon wherever possible to create documents that are understandable by non-lawyers, without introducing fatal ambiguities that are typical of online documents offered at cut-rate prices or available for free. Even better, our clients are pleased to discover that they actually understand what has been drafted for them, and so will be able to make use of it in their businesses.