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Three Provisions You Cannot Operate Without In Your Operating Agreement

I previously discussed the importance of LLC operating agreements. Let's now examine three specific provisions that you should consider for inclusion into your agreement.

1. Transfer provisions.

An operating agreement typically contains some language about the circumstances under which a member may or must transfer his ownership interest in the LLC to another person or entity. Under the Kentucky Limited Liability Company Act ("Act"), a member may freely transfer membership interest to anyone. There are a number of provisions in the Act that tell us how the transferring member and the new owner are to be treated, one of which is that the new owner will not be a full member with the right to vote unless a majority of the other members vote to make the new owner a full member. If members are allowed to freely transfer their interests however, founding members may find themselves faced with new business partners they did not approve. Moreover, a member's interest could be transferred involuntarily, such as by death, divorce, or bankruptcy. You and your business partners should decide on a transfer provision that would limit uncertainty. Restrictions give members control over when, how, and why membership interests are transferable.

2. Deadlock provisions.

Management or member deadlock occurs when a company's decision makers are evenly split on a matter and neither side will relent. It is a potentially fatal problem; under the Act, the remedy for deadlock is judicial dissolution. There are, however, many strategies that can be put into your operating agreement to avoid this problem, such as:

  • The opposing member may be allowed to withdraw from the LLC.
  • The operating agreement may require that a deadlock at the manager level be subject to a vote of the members.
  • The members may be required to take the issue to binding arbitration.

The common feature of these strategies is that the LLC will continue as a functioning business after the deadlock.

3. Additional Capital Contributions.

An operating agreement will usually state the amount of money or the value of property each member initially contributes to the company for operations, known as initial capital contributions. As an example, three people may decide to start a business and agree that each of them will give the company $3,000 so the company has $9,000 in start-up capital. Most operating agreements also have language about additional money from the members, known as additional capital contributions. Because the Act allows flexibility, that language may state that members are not required to make additional capital contributions, or it may require additional capital contributions and allow for one member to make an additional capital contribution for another member that fails to make that contribution when due in exchange for a portion of that member's membership interest. Frequently, when considering these possibilities, members fail to consider the effect of the language.

Generally, LLC members are not individually liable for the debts of the LLC if the LLC cannot pay its creditors. However, a court may ignore this protection if there is additional capital contribution language that can be read to require the members to pay LLC debt that the LLC cannot pay itself. The key is careful drafting so as to avoid any unintentional consequences.

Every successful business encounters bumps in the roads. An operating agreement is a road map, a tool to navigate through difficult obstacles. For more information on operating agreements and how to form your own limited liability company, please contact the Corporate Attorneys at McBrayer PLLC.

Thomas D. Flanigan is a member of McBrayer law in the Lexington, KY office. Mr. Flanigan specializes in the areas of entrepreneurial business, lending and commercial services and mergers and acquisitions. He can be reached at tflanigan@mcbrayerfirm.com or 859-231-8780, ext. 1211.

This article does not constitute legal advice.

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