Why a Solid Operating Agreement Will Save Your Business From the Inadequate Default Provisions of the NYLLC Law.

Although New York State law requires that all limited liability companies adopt operating agreements, many small business owners will either download a basic template from the internet and assume that all bases are covered or fail to adopt an operating agreement altogether. For the LLCs that are running with basic templates or no agreement at all, owners won't typically notice an issue until there is a dispute amongst them or the business faces a problem that would otherwise be addressed in a well-crafted agreement.

The operating agreement, although less consequential in a single-member LLC, acts as the constitution for your business. It addresses who manages the day-to-day affairs of the company, how new members are admitted, what happens if there is a dead-lock in decisions that need to be made, etc. When LLC owners fail to adopt an operating agreement or use a lackluster online template, they will find themselves at the hands of the default provisions of the NY LLC law. These provisions can be found in the NY LLC Law and are meant to provide a baseline for how LLCs are expected to operate in New York State. Sometimes they can be beneficial, other times they are just a headache waiting to happen.

For LLCs with three or more members, having a well-drafted operating agreement is make or break for some companies. While all members may be happy and excited to start a new venture together, complications arise, friendships and business relationships sour and disputes that were never thought possible could bring a thriving business to its knees. Below is an example of one of the many default provisions that are in place should your business lack an operating agreement or have a faulty one at best.

DEFAULT PROVISION EXAMPLE - SHARING OF DISTRIBUTIONS

For anyone that is unfamiliar with the term distribution, it's basically how members are paid, i.e., receive their share of the profits of the business. LLC owners are considered members and they take a distribution as opposed to a salary. Distributions can be weekly, monthly, or annually; it depends on the terms agreed upon by the owners. According to NYLLC Law § 504, without an operating agreement or one that addresses distributions, the default provision states that "all distributions shall be allocated on the basis of the value, as stated in the records of the limited liability company, if so stated, of the contributions of each member, . . . to the extent they have been received by or promised to the limited liability company and have not been returned to any such member."

What does this actually mean? Well, let's say you own a business with two partners, one of you contributes $100,000 towards the business, you contribute $100,000 and the other partner contributes $400,000 and you all agree that you are equal (1/3) owners of the company, but you never adopted an operating agreement or you have one, but it doesn't cover distributions or how ownership is split. Relying on the default provisions here, it would mean that you and your other partner who contributed the same amount are entitled to roughly 16% of the distributions, while the third partner who contributed more, would be entitled to roughly 66% of the distributions. If you understand basic math, those percentages do not equal out to a 1/3 ownership for each business partner.

Just to belabor the point here, let's say one month your company brings in massive revenue and the company looks to make $500k in distributions to owners. Under the example above, you and partner 2 would receive $80,000 and the third partner would receive $330,000. In reality, what might occur is that you're all splitting profits equally, but partner 3 eventually speaks with a lawyer and learns that he should be getting a much larger distribution based on the terms of your operating agreement or lack thereof. Herein lies the importance of having a well-drafted operating agreement. With a solid agreement, something like this scenario can be completely negotiated, avoided and addressed at the inception of the business and prevent needless litigation and dispute between the owners.

The example above is only one of many that points out the inefficiencies and inadequateness of the default provisions. That is why having a thorough, well-crafted operating agreement is crucial to providing stability and security to your business and setting the expectations for all members from day one.

If you have any questions about LLC operating agreements or would like to set up a consultation, please contact us or use the button above to schedule a consult today!

Disclaimer: This blog post and similar posts are not to be considered as providing legal advice. The discussion here is meant for educational and informational purposes only and shall not create an attorney-client relationship with the readers of this content.