Financing Your Small Business

Corporate Governance for Limited Liability Companies

Like corporations, limited liability companies (LLCs) are creations of the state. In contrast to a corporation, an LLC has a great amount of flexibility in how it is governed and operates. That said, if you hope to attract capital, it would be wise to follow a few suggested guidelines. Some LLCs are run very informally and some are operated like a corporation.

Operating Agreement

The governing document of an LLC is called an operating agreement. Many states require an LLC to have an operating agreement, and in any event, an operating agreement is highly recommended if there are two or more mem­bers of an LLC. It can eliminate misunderstandings among the owners.

The operating agreement will define the following:

• the different classes of ownership, if any, and the capital contributions of each member;

• how the profits and losses of the company will be allocated among the members;

• how the company will be managed and how decisions will be made;

• the indemnification and limitation of liability for members and managers;

• how new members are admitted to the company;

• the rights and duties of members;

• whether meetings are required and how voting is to take place;

• how membership units may be transferred and how a member may withdraw from the company;

• under what conditions the company may be dissolved and the proce­dures for winding up the operations of the company;

• how the operating agreement may be amended; and,

• rules regarding partnership taxation.

The operating agreement is a private document among the members of the LLC. It is not filed with the state. Each member of the LLC should sign the operating agreement since it represents, in essence, a contract among the members.

Members of an LLC are normally entitled to vote on enumerated matters in the operating agreement, and the operating agreement may be amended as provided in its provisions. (A sample operating agreement is included in Appendix C.)

Managers

Decisions in an LLC can be made by the members, one or more managers, or a board of managers, which can operate much like the board of directors of a corporation. If an LLC is run by the members, they typically vote

According to each member's percentage interest in the company. Meetings are held regularly and everyone participates in the decision-making process. At some point, this system can become cumbersome, especially if there are a lot of members.

If the decisions are left to a manager or board of managers, members of the LLC typically do not participate in all of the decision-making processes. Managers operate the company and the members take on a more passive role. This system is typically used when the members are investors and do not wish to take an active role in the operation of the company.

A manager does not have to be a member of the company, but often will hold some percentage of the membership. A manager of an LLC does not have unlimited personal liability like the general partner of a limited part­nership, and a manager, or for that matter any member, can be another entity, like another LLC or corporation.

Officers

An LLC can have officers much like a corporation. If there are officers, they would typically be appointed by the managers or designated in the operating agreement and they would be responsible for the day-to-day operations of the company. The managers would then take on a role similar to the board of directors of a corporation overseeing the activities of the officers and answering to the members.

Meetings

While most states do not require LLCs to hold meetings of their members, an LLC should hold a meeting of the members at least once a year. Just like a shareholders' meeting of a corporation, an annual meeting of the members is a great opportunity to discuss the past years' events of the company and rat­ify the decisions of the managers. In addition, the operating agreement can provide that a percentage of the members can call a meeting at any time.

Sale or Issuance of Membership Units

Unlike the articles of incorporation of a corporation, the articles of organi­zation of an LLC do not define its total authorized capital structure, and many times, neither does the operating agreement. If an LLC is looking to raise capital, however, it is advantageous to come up with a capital structure and define it in the operating agreement.

Here is a suggestion. Define three classes of membership units: A, B, and C. Class A membership units are reserved for issuance to the founding members of the company. Class B membership units are reserved for issuance to managers, officers, and consultants as performance incentives, just like stock options are used in a corporation. Class C membership units are reserved for sale to investors.

Later on, the LLC can create and define more classes of membership units, if needed to raise additional capital. The advantage in defining differ­ent classes of membership is that an LLC has the ability to allocate the net profits of the company among the classes differently. For example, unequal portions of the net profits for a period of time could be allotted to investors and founders.

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