Strategies for Drafting an Effective Operating Agreement

Members of a limited liability company (“LLC”) can draft or revise operating agreements as needed to create a set of rules that governs the relationship between the members and the LLC. Most operating agreements will generally include provisions related to membership meetings or voting rights. However, writing an effective operating agreement requires careful planning, examining uncertainties, and creating a clear roadmap of processes and procedures that can be trusted in the future. This article will identify issues that are often overlooked when drafting an operating agreement and strategies to consider when writing an effective operating agreement. 

Strategy #1 Consider Hypotheticals Scenarios 

Writing a list of hypothetical scenarios that would impact the operations of an LLC can allow members to solve problems before they ever occur. Members should consider making a list of hypothetical scenarios that could affect the LLC or its members, including situations such as death, divorce, or a member disappearing to Tahiti. After making a list of hypothetical scenarios, members should discuss the desired result and incorporate provisions needed to achieve that result into the operating agreement. Planning for every situation will always remain impossible. However, drafting an operating agreement that considers specific situations can allow members to solve problems before they arise in the future. 

Strategy #2 Consider the Tax Implications

LLCs are the most flexible legal entity available. LLCs can have (and frequently do have) tax statuses different from their legal entity status. Under the default tax rules, LLCs with more than one member are taxable as a partnership, and LLCs with a single member are taxable as a disregarded entity. However, LLCs can also elect to be taxable as a C corporation or an S corporation (when eligible). Therefore, operating agreements should incorporate tax-specific provisions that reflect the intended tax status and comply with applicable tax code provisions. 

Strategy #3 Consider Voting Rights 

LLCs provide tremendous flexibility with member voting. A common technique when structuring an LLC and writing an operating agreement is to create different classes of equity that provides different voting rights to members. For example, an operating agreement can include provisions that issues Class A equity and Class B equity, with members owning Class A equity having greater rights, sole voting rights, or no voting rights. Operating agreements can also allow classes of equity to vote only on specific matters. Other than major LLC decisions (merger, sale, etc.), members of an LLC are free to alter their voting rights through an operating agreement. 

Strategy #4 Consider the Exit

Every member of an LLC will have an exit. There are various types of exit events that need to be considered when drafting an operating agreement, including redemptions, dissolutions and wind-downs, and interest sales. Exit planning can get tricky when exit terms are not included into the operating agreement, forcing members to negotiate and resolve matters amongst themselves. Having defined terms in the operating agreement that provides clear terms and procedures will ensure members can exit the LLC as quickly, efficiently, and fairly as possible. 

Strategy #5 Consider Restrictive Covenants

Employment agreements frequently include restrictive covenants. However, operating agreements can impose similar restrictive covenants upon managers or members. For example, an operating agreement can prohibit members from soliciting employees, competing with the LLC, or disclosing confidential information. Although the Florida Revised Limited Liability Company Act provides some restrictions on competition, operating agreements can be drafted to include restrictive covenants that impose greater or lesser restrictions on members or managers. Operating agreements can also provide the LLC with specific remedies following a breach that may not otherwise be available under the law.

Strategy #6 Consider Deadlocks

Manager or member voting deadlock can render LLC operations impossible. However, operating agreements can include specific deadlock-breaking mechanisms that allow deadlocks to be decided based on procedures that were previously agreed upon by the members. Members are free to get creative with their deadlock provisions and can utilize any tie-breaking mechanism they can think of, such as coin flips, rounds of golf, or having a 3rd party decide the issue. Incorporating deadlock provisions into an operating agreement will ensure that the LLC can still function even when its members or managers cannot agree.

Strategy #7 Consider Ownership

LLC members are often individuals. However, LLC interests can also be owned by entities, trusts, other legal entities, or spouses as tenants by the entireties. Considering the potential advantages and disadvantages of each ownership type must be considered when drafting an operating agreement and structuring an LLC. Ensuring the operating agreement has the language needed to effectuate the desired ownership structure is critical to preserve flexibility and avoid potential challenges in the future.

Conclusion 

There is no perfect way to write an operating agreement. Each operating agreement should be carefully drafted to meet the specific needs of the LLC and its members. However, following the strategies identified in this article can assist members with identifying frequently overlooked issues when reviewing or drafting an operating agreement.