Changing Your LLC Operating Agreement as Your Company Grows

By Cliff Ennico

July 22, 2014 6 min read

"My two partners and I formed a limited liability company several years ago.

"Our business has grown substantially, and we now have several investors as well as employees who own -voting shares in our company.

"We're still using the operating agreement that we signed when we first started the company, but I have to believe we need to make some changes as what made sense back then for 'just three guys' may not make sense for a fast growing entrepreneurial company. Any suggestions?"

First of all, you are wise to ask this question before your minority owners start demanding changes (or worse, begin a lawsuit to force the changes).

You should ask your company lawyer to spend an hour reviewing your Operating Agreement and make specific recommendations for change. Here are some ideas:

Management by Managers. Your Operating Agreement probably says your company will be managed by the members acting as a partnership. That's OK when it's just the three of you, but with so many people involved now you may want to separate management from ownership by becoming a "manager managed LLC."

The three of you would continue to run the company, only as "managers." Certain very important matters (such as mergers, acquisitions or a change in the company's business) would have to be approved by a majority of your company's members. Minority owners would receive notice of important decisions and the right to be heard — very important for keeping investor lawsuits at bay.

Units of Membership Interest. Your Operating Agreement probably assigns each member a percentage of the LLC's profits and losses. Time to grow up. Like a corporation, your LLC should authorize units of membership interest, which function much the same as shares of stock in a corporation. It's a lot easier to tell a new investor he will be receiving 5,000 ownership units than it is to tell him he's getting 0.587433333 percent of the company.

Converting to units of membership interest will also make it easier for your LLC to convert into a corporation if and when you wish to do so.

Voting and Non-voting Shares. Your message says you have given non-voting shares to some of your employees. Are their rights spelled out in the operating agreement? If not, that needs to be fixed immediately as most state LLC statutes do not spell out the rights and obligations of non-voting members.

Your operating agreement should authorize the managers to issue up to X units of non-voting membership interest, granting owners of these interests the right to receive profits and losses from the LLC's business and a percentage of the proceeds of any acquisition or liquidation transaction. A simple statement that "owners of non-voting units have all of the rights of membership in the company other than the right to vote on matters affecting the company's business, operations and affairs" may be sufficient.

Pre-Emptive Rights. Consider giving your non-voting members the right to buy additional units if their percentage ownership of the company is diluted in a later offering.

Restrictions on Transfer of Shares. Your operating agreement should contain buy-sell provisions restricting members from selling their shares openly without first giving other members a "right of first refusal" to buy them. If it doesn't, now is the time to add those provisions.

Voting members of an LLC should not be allowed to quit or otherwise withdraw from the business voluntarily without selling their shares back to the company or to the other members. You should allow voting members to transfer their shares to family members in their wills (as long as they convert to non-voting shares upon the owner's death). Transfers of non-voting shares should not be restricted — since by definition these shares have no say in the management of the LLC, you shouldn't really care who owns them.

Owners of non-voting shares should be required to notify you when they transfer their shares — otherwise you won't be able to track them down if they are entitled to payments or distributions down the road.

Valuation of Shares. When an LLC is first getting off the ground, you should use strict mathematical formulas value the company in order to determine the buyout price for a withdrawing member's shares — for example, two times the earnings before income tax of the company averaged over the past three years, or 50 percent of the company's gross sales averaged over the past three years.

As a company grows, however, multiples of sales and earnings may no longer reflect the true market value of the company. Some high-tech companies have recently paid billions to acquire startups that didn't even have revenue yet, much less profit!

In the event a withdrawing member's shares have to be repurchased, your operating agreement should require the company to be valued by an independent appraiser selected by the managers based on current market conditions. Yes, independent valuations are expensive, but you can afford them now. Congratulations!

Cliff Ennico ([email protected]) is a syndicated columnist, author and former host of the PBS television series "Money Hunt." This column is no substitute for legal, tax or financial advice, which can be furnished only by a qualified professional licensed in your state. To find out more about Cliff Ennico and other Creators Syndicate writers and cartoonists, visit our Web page at www.creators.com.

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