STRATEGY GUIDE: BUSINESS OWNERS NEED TO VIEW LLC OPERATING AGREEMENT AS A BUSINESS STRATEGY DOCUMENT—NOT JUST LEGAL PAPERWORK

Starting a business with another person often begins with optimism. The founders may be friends, relatives, longtime colleagues, or professionals who believe they share the same vision. In the beginning, questions about control, compensation, disagreement, incapacity, or exit can seem unnecessarily negative. Everyone is focused on launching the company and making it successful.

Unfortunately, many of the most expensive business disputes begin with exactly that assumption.

A well-drafted operating agreement is not simply paperwork that belongs in a company file after an LLC is formed. It is the document that can determine who controls the business, how important decisions are made, how profits are distributed, what happens when additional money is needed, whether an owner can sell his or her interest, and how the company responds when the owners no longer agree.

For Georgia LLCs in particular, operating agreements can be extraordinarily important because Georgia law expressly favors freedom of contract and the enforceability of operating agreements. Georgia law also allows an operating agreement to address a broad range of matters involving the management and affairs of the LLC.

At Elkhalil Law, P.C., we view the operating agreement as much more than a formation document. Properly drafted, it is a roadmap for operating, growing, protecting, and eventually exiting the business.

Decide Who Actually Controls the Company

Ownership and control are not necessarily the same thing.

A company may have two owners who each hold 50 percent of the equity but agree that one will manage the company's day-to-day operations. Another company may have several passive investors but only one or two individuals making operational decisions. A family-owned business may divide ownership among family members while limiting management authority to those actively involved in the company.

The operating agreement should make those distinctions clear.

Georgia LLC law generally provides that management is vested in the members unless the articles of organization or a written operating agreement provides for management by one or more managers. The operating agreement can therefore be used to establish who has authority and what limitations apply to that authority.

That issue becomes especially important when a company begins entering significant contracts, borrowing money, hiring employees, purchasing assets, leasing property, or taking on investors.

A properly drafted agreement should distinguish routine business decisions from extraordinary decisions. A manager may reasonably need authority to pay ordinary expenses without obtaining a vote every time the company buys office supplies. The same manager, however, may not be intended to have unilateral authority to borrow $500,000, sell the company's principal assets, admit a new owner, or enter a ten-year lease.

The agreement should say so.

Address Voting Before There Is Something to Fight About

One of the worst times to determine voting rules is after the owners disagree.

A good operating agreement establishes which decisions require a majority, a supermajority, unanimous consent, or some other level of approval.

It should also address how voting power is calculated. Does each member receive one vote? Is voting based upon percentage ownership? Do certain owners have special approval rights? Are there decisions that cannot be made without the consent of a particular founder?

These details can become enormously important.

Consider a company owned 51 percent by one person and 49 percent by another. If every decision is governed by majority vote, the 51-percent owner may effectively control virtually everything. That may be exactly what the parties intended—or exactly what they did not intend.

Likewise, a 50/50 company can face the opposite problem. Neither owner can force a major decision when the other disagrees.

Without a deadlock mechanism, the company itself can become trapped.

An operating agreement can establish mediation, a tie-breaking mechanism, a buy-sell procedure, or another process designed to resolve deadlock before the owners are forced into expensive litigation.

Decide What Happens When the Business Needs More Money

Nearly every business requires capital, but owners often focus only on their initial contributions.

What happens six months later when the company needs another $100,000?

Is each owner required to contribute proportionately? What if one owner cannot afford to contribute? Can another owner put in the money? Is that money treated as additional equity or as a loan? Does the additional contribution change ownership percentages? Can an owner be diluted?

These are not theoretical questions. They frequently arise during growth, unexpected financial difficulty, litigation, expansion, or major capital investment.

The operating agreement should establish the rules before the company is desperate for money.

Otherwise, the owner willing to fund the company may believe additional ownership is justified while the other owner believes his or her existing percentage can never be reduced.

Both may sincerely believe they are right.

Separate Ownership From Employment and Compensation

Another common source of conflict is the assumption that equal ownership means equal compensation.

Suppose two people each own 50 percent of a business. One works sixty hours per week managing employees, generating revenue, and dealing with clients. The other becomes increasingly passive.

Should they receive the same salary?

Should they receive the same distribution of profits?

Those are actually different questions.

Ownership determines economic rights in the company. Compensation can reflect work performed for the company. Distributions involve company profits and ownership interests. The operating agreement and related employment or compensation arrangements should distinguish among them.

Without that distinction, a successful business can gradually become a source of resentment.

Protect the Company When an Owner Wants to Leave

Every owner will eventually leave a business.

The departure may result from retirement, disability, death, divorce, financial hardship, disagreement, or simply a decision to pursue something else.

The key question is whether the departure has been planned.

An operating agreement can restrict transfers of membership interests and establish rights of first refusal, approval requirements, permitted transfers, and buyout rights.

This can protect the remaining owners from suddenly finding themselves in business with someone they never selected.

It can also provide a predictable path for the departing owner.

Establish a Method for Valuing the Business

A buyout provision that says an owner may be bought out for “fair market value” may sound sufficient.

It may not be.

Who determines fair market value?

Will the parties select one appraiser? Will each side select an appraiser? What happens if the valuations are dramatically different? Does the valuation include discounts for minority ownership or lack of marketability? Is goodwill included?

The valuation method can make the difference between a relatively orderly buyout and years of litigation.

Good agreements address valuation while everyone still hopes it will never be necessary.

Address Death, Disability, Divorce, and Bankruptcy

Business owners often plan for voluntary departures but overlook involuntary ones.

What happens if a member dies?

Does the surviving spouse inherit voting rights or merely an economic interest? Does the company have a right or obligation to purchase the deceased member's ownership? Is there life insurance intended to fund the purchase?

What happens if an owner becomes permanently disabled?

What if an owner's membership interest becomes involved in a divorce or creditor proceeding?

An operating agreement cannot eliminate every outside legal issue, but it can establish how the company and the other owners will respond.

Understand That Fiduciary Duties Can Also Be Affected

Georgia law imposes duties upon LLC members and managers under certain circumstances, but it also gives LLCs substantial contractual freedom concerning those duties. A written operating agreement may expand, restrict, or eliminate certain duties and liabilities, although statutory limitations remain, including limitations relating to intentional misconduct, knowing violations of law, and certain improper personal benefits.

This is another reason an operating agreement should not be treated as a generic online form.

Language concerning management duties can have significant consequences if the owners later become adverse to one another.

Even a Single-Member LLC Should Have a Governance Plan

Single-member LLC owners sometimes assume there is no need for an operating agreement because there is no one else with whom to disagree.

But governance is not relevant only to disputes between owners.

A written agreement can establish authority, document the owner's intention to operate through a separate entity, address succession, and provide a structure for adding future members or managers.

It can also become important when dealing with banks, investors, purchasers, or other third parties performing diligence on the company.

The Best Operating Agreements Are Written Before They Are Needed

There is a recurring pattern in business litigation: the parties leave difficult questions unanswered because addressing them feels unnecessary while the relationship is good.

Then the relationship changes.

At that point, every missing provision becomes something the parties must negotiate while they are already in conflict.

A strong operating agreement does not assume the business relationship will fail. It recognizes that successful companies encounter change.

Owners join and leave. Businesses need money. Companies grow. People become sick. Founders disagree. Opportunities arise. Buyers make offers.

The objective is to have a framework capable of handling those events.

At Elkhalil Law, P.C., we assist Georgia businesses with LLC formation, operating agreements, ownership structures, governance, buy-sell provisions, business transactions, and disputes among owners.

An operating agreement should not merely describe the company you have today.

It should help protect the company you hope to have tomorrow.