When two or more people own an LLC, the owners need a written LLC Operating Agreement. However, don’t just grab a template from the internet. The LLC Agreement is a contract between the owners about how they will handle certain common situations. Because these agreements are often very long, I’ve listed the 6 essential clauses in an LLC Agreement that you need to review.
First: Why You Need an LLC Agreement
Most people starting a business do not want to think about conflict. Neither do they want to think about an exit strategy. Unfortunately, conflict inevitably arises and people inevitably exit the business. This is why you need to discuss these situations at the start and decide how you will manage them if or when they occur.
Your LLC Agreement should include clear instructions for how the company will run. It should also make provisions and plan for the future. In addition to the business model, here are 6 often overlooked essentials to address in your Shareholder or LLC Agreement
1. How to Split Voting Between Partners
There are several ways to manage voting.
For instance, if four people own equal shares of the company, each gets 1 vote.
But what if one person owns more than the others? For example, what if 1 person owns 50% of the company and 2 people each own 25% of the company? Does the 50% owner get 2 vote or 1 vote?
We can complicate this even more if the LLC is own by 3 people, but two of the owners are married. Does the married couple get 2 votes or only 1 vote?
So, start by addressing who has voting rights on major decisions for the company.
Once that has been determined, decide who can be the tie-breaker. How do you split voting if there is an even tie? Do you simply not take action. How about using a mediator (that can get expensive)? What about flipping a coin?
2. What to Do when an Owner Leaves (or Dies)
We don’t know the future. Whether it is through leaving for another opportunity, to get married, or eventually passing away, one of your partners will eventually leave the company.
What happens then? Who replaces them? This is often one of the most contentious debates.
Can the exiting owner sell their portion of the company?
Can they pass it along to their child?
Is the company required to purchase the existing owner’s share? Does it have a right of first refusal?
Don’t forget the money. After deciding when and how an owner can sell their ownership in the company, the next debate is purchase price. Of course, the seller always overvalues the company and the buyer (the remaining owners) undervalue it.
Determine how to calculate the purchase price when you start the company. This saves a lot of legal fees, accounting fees, and strife later on. It might also help you preserve your relationship with your (now) former business partner.
Not to be morbid here, but don’t forget death. If you are hit by the proverbial bus, what happens? Does your estate or spouse get to take your place? Does the company buy out your ownership? If so, how much will they pay your estate? These things must also be decided and written in your LLC Agreement.
3. What to Do if the Company Gets Sued
It happens to the best of us. At the offset of a company, you should establish rules for what the operating procedures are in the case of a lawsuit, regardless of what it is caused by.
For example, if the company is sued in a slip-and-fall case, you likely want all owners to be reimbursed by the company for their litigation fees.
However, what if one owner embezzles money from the company? Do you want the company to reimburse the bad owner for the litigation fees? Probably not. Your LLC Agreement needs to address this situation.
While state law contains default provisions – who can be reimbursed for litigation expenses – there are many practical and cash-flow things to consider. This is where an attorney’s advice is useful.
4. Should the Company Have a Non-Compete Rule?
Some companies include a provision saying that their shareholders or partners cannot work for any other companies in the same field. Is this right for your company? The answer depends on your industry and situation.
This clause should be carefully written. Often owners compromise with allowing certain types of competition while banning others.
For example, if three people own a French cuisine restaurant, they might prohibit each other from owning another restaurant of similar cuisine or price-point. However, they might allow an owner to also own a fast food restaurant or a coffee shop.
5. Who Audits the Records?
Can any owner audit the company’s records at any time?
Do you need a reason to do it? Do you have to be approved in advance?
Can you make copies and do you have to pay for the administrative cost of preparing the records?
Again, state law has default provisions but do not accept the default with considering the consequences.
6. How Does the Company Close?
This goes back to addressing the hard times when you are just starting out: what happens when the company wants to (or needs to) close? You may have heard entrepreneurs talk about having an exit strategy when they begin the company. This is good advice.
When a company closes, it doesn’t simply close its doors. After the company pays its debts, there might be cash or property left. How will you distribute this?
While it is easy to distribute cash, what happens if you need to distribute a truck or a building or inventory? You can’t get each owner part of a truck? Do you want to share ownership in a building?
This is another reason why involving an attorney and accountant will benefit you. Much of these questions are answered by the US Tax Code. The LLC Agreement can also give certain owners preferential status to certain company assets. Another strategy is proper titling of assets (a legal term for identifying who owns an asset, such as a building or vehicle).
How to Get the Help You Need
Many companies get started on the wrong foot by not addressing these issues in their LLC Agreement. Trust us, because we see the aftermath every day: it’s better to decide them up front.
For help with your business, contact Concerto Law today! We can help you build a successful business that allows you to live the life you really want.