When forming a Limited Liability Company (LLC) in Ohio, filing the Articles of Organization is just the beginning. The true foundation of your business is the Operating Agreement (also known as the LLC Agreement). This document governs the relationship among the members (or owners) of the LLC and the company itself, and it dictates how the business will operate.
For small business owners, startups, and LLCs, this document is essential. While Ohio law provides default rules, the Operating Agreement allows you to “supplement or alter” those defaults to fit your unique needs and ensure robust governance.
The Consequence of No Operating Agreement
What happens if you skip the Operating Agreement? Without a properly drafted, customized agreement, your LLC will automatically be governed by the default rules set out in the Ohio Revised Code. These generic statutory rules attempt to provide a one-size-fits-all solution. But they may not align with your business goals and can lead to unforeseen tax and other financial consequences.
For example, under the default rules, the LLC is not required to distribute profits to the members at any point in time. The members are only entitled to their share of any distribution after the company is wound up, assets are liquidated and creditors have been satisfied. It probably comes as no surprise that this is not what most startup founders intend when they form an LLC.
Most critically, the default provisions in state law lack specific protections like tailored buy-sell provisions (discussed below) or dispute resolution mechanisms that can keep you out of long, drawn out and expensive litigation. Customizing your LLC Operating Agreement with these kinds of common sense provisions can prevent a simple disagreement from turning into a business-paralyzing deadlock.
A properly drafted Operating Agreement is the best investment you can make for your company’s stability. Here are the five critical clauses every multi-member LLC Operating Agreement should contain:
1. Capital Contribution Valuation
This clause defines what each member contributes to the company and how that contribution is valued, which is key to determining membership interests. If you think of your membership interest like shares of stock, then your capital contribution is what you paid for your shares.
- Valuing Non-Cash Contributions: It is critical to explicitly state how non-cash contributions, such as services rendered (aka sweat equity) or transfer of intellectual property, are valued for each member’s initial capital account. This clarity avoids future disputes over each person’s membership interest. Time and time again, I’ll see the member who contributed cash argue that a member who only contributed sweat equity was never really a member. They were just a service provider who worked for the “real” owner, the member who put up the money.
- Additional Contributions (LLC capital calls): The Operating Agreement must specify whether members are ever obligated to make additional contributions after their initial contribution. Most importantly, this clause must outline the consequences for failing to contribute additional capital (e.g., reduction of the defaulting member’s interest in the company or even a forced sale of their membership interests).
2. Management Structure and Key Decisions
Once you’ve settled on capital contributions and ownership percentages, the next step is defining who runs the day to day operations. Clarity here is vital for defining who has the power to do what, especially when those decisions legally bind the LLC (i.e., binding contracts).
- Management Designation: The Operating Agreement can explicitly state whether the LLC is Member-Managed or Manager-Managed, though the most recent revisions to the Ohio statute does not require this distinction. Nevertheless, taking the time to define the management structure is essential for day-to-day operations.
- Supermajority Consent: The Agreement should also identify any “major decisions” that require a supermajority or even unanimous vote to protect everyone’s interests. For example, this might include bringing in additional members or investors or selling all or even a substantial portion of the company’s assets.
3. Buy-Sell Provisions
A strong LLC Operating Agreement must also anticipate the future. At some point in time, one of the members will likely want to leave the LLC to do something else. Or there may be such a fundamental disagreement that everyone is better off going their separate ways. Or perhaps a member can no longer work in the company because of death or disability.
Buy-Sell provisions address these “what if” scenarios, often by requiring a departing member to sell their ownership interest back to the company or the remaining members based on a set formula or other pre-determined value.
- Transfer Restrictions: Transfer restrictions typically give the LLC or the other members the right to purchase the departing member’s interest before they can attempt to sell to an outside buyer or even leave their interest in the company to their family in their will or trust.
- Involuntary Transfers: These clauses address what happens to a membership interest upon an involuntary transfer event, such as a member’s death or bankruptcy. They ensure that the business can continue without dissolving and that the remaining owners retain control.
4. Fiduciary Duties and Indemnification
Beyond structure and ownership, the operating agreement should clearly define the ethical and legal behavior expected of all members.
- Waiving Certain Rights: Ohio’s LLC law allows members to waive or modify certain fiduciary duties (like the duty of loyalty). For example, your operating agreement might include a non-compete clause or language requiring you to bring business opportunities to the company first before trying to pursue them on your own. Or you and your business partners might instead decide that everyone can have whatever outside business interests they so choose.
- Indemnification: The agreement should also include clauses for indemnification. This generally obligates the LLC to protect and pay for the legal costs of a member who is sued because of actions they take on behalf of the company. It is very common for lawsuits against small businesses to name the individual members of the LLC. But unless the individual members did something egregious, the LLC should agree to cover the expenses associated with defending that lawsuit.
5. Dispute Resolution
Finally, the most practical provision in your entire agreement is the mechanism for resolving internal disagreements. Establishing a clear dispute resolution process now, while everyone still “knows, likes and trusts” each other can save your business when (not if) a disagreement arises. Without a clear, predefined path, a simple disagreement can escalate into a legal battle that tears the business apart financially, operationally, and emotionally.
A good dispute resolution process will make the following steps mandatory:
- Negotiation: Members must first attempt to resolve the dispute among themselves in good faith. This step might even require consultation with a trusted advisor that the members can rely on to be a “cooler head.”
- Mediation: If negotiation fails, the parties should submit the dispute to a neutral third-party mediator. This step can resolve disputes short of going to court as long as everyone involved is more interested in resolution than finger pointing and blaming others for the underlying problems.
- Arbitration or Litigation: Arbitration or mediation should generally be the last resort. Business divorce cases can often be just that–incredibly nasty and expensive divorces. I’ve seen business partners spend tens of thousands dollars in legal fees fighting over a business just to get back at the other member for some perceived slight. After months in the litigation process, the attorneys are the only ones who have really “won.” And often the business is no longer financially viable and the customers, clients and key employees have all moved on.
Protect Your LLC. Don’t Rely on Generic Templates.
The complexities of Ohio business law and the need to personalize these clauses mean that using a generic online template is a high-risk gamble.
Schedule a consultation with MSN Law Office in Columbus, OH, to ensure your LLC has the customized Operating Agreement it needs so that legal “stuff” doesn’t come back to bite you.
