California Business and LLC Attorney Answers FAQs about a California LLC Operating Agreement
|Prepared By: Melissa C. Marsh, Los Angeles Business And LLC Attorney
Written: March 2009
Q. What is an LLC Operating Agreement?
A. Pursuant to California Corporation's Code §17050, every California LLC is required to have an LLC Operating Agreement. Next to the Articles of Organization, the LLC Operating Agreement is the most important document in the LLC. For multi-member LLC's, the operating agreement should be about 50 to 70 pages, depending on the number of people involved. However, a single-member LLC operating agreement need only be about 15 to 30 pages. An LLC Operating Agreement is the primary contract between and among the members of a limited liability company (LLC). The LLC Operating Agreement governs the membership, management, operation and distribution of any income of the LLC. A LLC Operating Agreement, at a minimum, should address the following:
- Whether the LLC is Member or Manager Managed;
- The number of members;
- The member's duties, rights and obligations;
- The method for choosing managers, their terms, duties, and salaries;
- The method for calling meetings, and the time and place for meetings;
- The member's voting interests;
- The members profit and loss distribution;
- The method of elections;
- The capital structure and financing mechanisms;
- The record keeping procedures;
- The member's withdrawal rights;
- Grounds for terminating a member;
- The member's right to sell or transfer Membership Interests; and
- The duration (life) of the LLC.
Q. Why do I need an LLC Operating Agreement for my California LLC?
A. First, in California every limited liability company is required to have an LLC Operating Agreement. Aside from being required, the LLC Operating Agreement is essential to any LLC for three primary reasons: (1) it preserves or strengthens the members limited liability protection to safeguard their personal assets; (2) it sets forth operating rules and procedures to limit financial and management misunderstandings, and (3) it ensures you get the primary benefit of operating as LLC – the flexibility to establish your own operating and governance procedures, as opposed to the default rules set forth in California's Corporations Code.
Reason No. 1 - Protecting Your Limited Liability Status.
One of the main reasons individuals opt to form an LLC over a partnership is the limited liability protection afforded to members of a California limited liability company, but not to partners. Having a well written Limited Liability Company Operating Agreement will help ensure the courts will respect your limited personal liability. This is particularly important with a single member LLC, where without the formality of an Operating Agreement, the LLC will look a lot like a sole proprietorship and the courts will be more apt to consider the LLC the simple "Alter Ego" of the sole member, as opposed to its own separate entity. Having a formal well written operating agreement lends credibility to the separate existence of the LLC.
Reason No. 2 - Limiting Lawsuits.
If you are a member of a multi-member limited liability company, the lack of a comprehensive well written Operating Agreement signed by all of the members substantially increases the risk of future disputes involving the company's management and the rights and obligations of the members. A well drafted LLC Operating Agreement can prevent disputes among members and provide methods to resolve disputes without the need for costly and emotionally draining litigation. Unfortunately, as a business attorney for over 10 years, I have seen too many disputes involving the members of an LLC that could have been either completely avoided, or resolved by a well drafted LLC Operating Agreement, but instead led to costly litigation and in some cases the demise of the LLC.
Reason No. 3 – Every Business Needs A Clear Set Of Rules.
Every business needs a set of rules to govern itself. With a corporation, it is the bylaws and hopefully a buy-sell agreement. With a partnership, it is a partnership agreement with hopefully buy-sell provisions. With an LLC, it is the Operating Agreement. Although California Corporation's code provides certain default rules and procedures when a California LLC Operating Agreement remains silent on a particular issue, it is not wise to rely on them, especially in light of the LLC's primary benefit—its flexibility in terms of management, profit distribution and the allocation of profit and losses without regard to membership interest. If you don't need flexible management or profit/distribution rules, then you are probably better off with a California corporation which affords most businesses better tax treatment.
Reason No. 4 – A Custom LLC Operating Agreement Enables You To Alter The Default Rules Set By California Law.
If you still desire to form an LLC with a generic online form operating agreement, then consider the following. California Corporate Code §17156 provides: "except as otherwise provided in the articles of organization, or the LLC operating agreement, if the members of an LLC have appointed more than one manager, decisions of the managers shall be made by majority vote if at a meeting, or by unanimous written consent." While this may not sound so bad, it can be. What if there are certain decisions the members expected would only be made by unanimous vote such as the sale of some, or all, of the LLC's assets, or acquisition of a large amount of debt? Absent a well drafted LLC Operating Agreement that provides terms requiring a super majority vote, or a unanimous decision, a simple majority can basically change the entire direction of the LLC and expose all of the members to additional risk.
Still not convinced. Then consider this. Absent a well written Operating Agreement, California law provides that the profits and losses of the LLC will be distributed equally amongst its owners, even if each member's investment in the LLC connotes a different distribution allocation. If the members of an LLC do not intend to invest equal amounts, or do not intend to share the profits and losses equally, an Operating Agreement must set forth each member's percentage interest and a description of how profits and losses are to be allocated.
Q. In California, Does a Single Member LLC need an LLC Operating Agreement?
A. Again, pursuant to California law every California LLC must have an Operating Agreement. A common mistake made by many single member LLCs is the assumption that an Operating Agreement is not required. In California, every limited liability company is required to have an Operating Agreement.
Ironically, it is actually more important for a single member LLC to have a well written Operating Agreement and to religiously hold its annual and special meetings of the sole member. This is because a single member LLC is more likely to be challenged in court as the "alter ego" of its owner. If such a challenge is successful, say good bye to your personal limited liability protection. If an attorney prevails in piercing the LLC veil, the member of the LLC may be held personally liable for the debts and obligations of the LLC. It is therefore very important for a single member LLC to adopt an LLC Operating Agreement and to follow the provisions set forth in that LLC Operating Agreement with respect to meetings of the members.
Q. Who signs the LLC Operating Agreement?
A. All the initial members of the LLC should sign the LLC Operating Agreement, and if any of the members are married then their spouses should also sign a spousal consent. If a new member is subsequently admitted to the LLC, the new member should sign a written agreement (commonly known as an Amendment) agreeing to be bound by the terms and conditions set forth in the LLC Operating Agreement.
Q. What is the difference between a Member- Managed and a Manager-Managed California LLC?
A. An LLC can be either "member-managed" or "manager-managed." The initial members (owners) can decide whether they, as members, want to each be responsible for managing the LLC or whether they want to elect one, two or three managers to run the LLC, similar to the way a corporation is managed by its Board of Directors. While it is a matter of choice as to whether you desire to be a member-managed or manager-managed LLC, I strongly suggest that there be an odd number of members (or managers) who will ultimately make the decisions. An even number of members (or managers) often poses a dispute resolution problem when the two members, or managers, cannot agree.
Q. How is ownership established with a California LLC?
A. Ownership in an LLC is usually structured in two ways: (1) by percentage interest or (2) by membership units, which are similar to shares of stock in a corporation. In either case, ownership generally confers the right to vote and the right to share in the profits of the LLC, as set forth in the LLC's Operating Agreement.
Although membership units are similar to shares of stock in a corporation, the LLC can distribute its ownership interests as it pleases, without regard to how much money or property a member contributes to the LLC. For example, if John contributes $10,000 of cash to an LLC but does not manage the business, and Jane contributes only $1,000 but runs the LLC on a daily basis, John and Jane can set forth in the Operating Agreement that each will have a 50% shares of the profit distribution.
Q. Is a California LLC required to have Officers?
A. Although an LLC is not required to have or appoint officers, it is typically a good idea for all LLCs to have a management structure that provides for a President, Secretary and Treasurer. One person can serve multiple officer roles.
Q. Why do I need an attorney to prepare a California LLC Operating Agreement?
A. As many of you are aware there are many online non-attorney service providers such as LegalZoom, MyCorporation, and BizFiling that will provide a standard LLC Operating Agreement (which they may state is custom simply because it includes your LLC's name, address, and member's personal information), but what it won't do is instruct the LLC owners on their rights and responsibilities under California law, or provide alternatives to the default rules provided under California law. Even where the default rules under California's Limited Liability Act may be appropriate, a well drafted LLC Operating Agreement (even for a single member LLC) may alter the statutory default provisions and where it cannot it will recite the code provisions so members of the LLC will be able to determine their rights and obligations by examining the Operating Agreement, without having to visit an attorney, or refer to the Corporation's Code for guidance. And even where a trip to the attorney's office is unavoidable, a well drafted LLC Operating Agreement will save you both time and money because the rules will be set forth directly in the LLC's Operating Agreement. The same holds true for Corporations. You can acquire standard 7 to 10 page Bylaws from an online service company, or you can have attorney prepare custom 30-page Bylaws that clearly set forth all of the corporate rules under which the corporation is governed.
If you would like to retain the services of Melissa C. Marsh to form and organize a California LLC, or to prepare a California LLC Operating Agreement, please call 818-849-5206 or Send us an Email.
California business lawyer, Melissa C. Marsh, is based in Sherman Oaks and West Hollywood, and serves individuals and businesses throughout Los Angeles County, including: West Hollywood, Miracle Mile, Beverly Hills, Century City, Santa Monica, Burbank, North Hollywood, Valley Village, Toluca Lake, Studio City, Sherman Oaks, Van Nuys, Encino, and Woodland Hills.
© 2009 Melissa C. Marsh. All Rights Reserved.