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Changing Your LLC Operating Agreement to Reflect the Growth of Your Business

Limited liability corporations (LLCs) are a relative newcomer to the tax code. They were first approved for use in 1977 when the state of Wyoming requested the formation of a business that could be managed and taxed like a partnership but protected from liability like a corporation. This desirable hybrid soon spread to all 50 states, each with slightly different requirements for registering an LLC and altering the original paperwork.

The basic premise remains the same, however. When members decide to register their business as an LLC, they draw up a document that lists the rules and regulations for the company's management. This LLC operating agreement is a governing snapshot of the company in its early stages. As the company grows, the operating agreement needs to be revised in order to reflect the company's new image.

How Does a Company Amend their LLC Operating Agreement?

When Should a Company Amend their LLC Operating Agreement

There are a number of reasons for a company to amend their operating agreement. Some of them stem from the need to clarify roles and procedures in an organization that is no longer composed of people who know each other well and have strong bonds of trust. Others reflect the reality that growing organizations require a more hierarchical structure and stronger protections over the company's interests and creative property.

Ultimately, the operating agreement is a contract, and like any contract, it should be changed when circumstances no longer make the original terms either practical or viable.

The following list includes instances when a growing company may need to make amendments to their LLC operating agreement.

When a business first gets started, typically just a few people are on board. These members may agree to manage the company together as a partnership. This is called a member-managed LLC. Each member has an equal ability to act on behalf of the business.

As the company grows, however, the influx of new members often creates a need to separate members and management. In this scenario, you will want to amend the LLC operating agreement from member-managed to manager-managed. Managers now play a direct role in the operation of the company, while members assume a more passive role—though they still may retain some interest in the company.

"Units of membership interest" is how LLCs define the amount of financial stake each member has in the company. Having units of membership interest is roughly akin to holding shares of corporate stock, and it is a simple way to allocate each member's interest in the company's total value.

Initially, you may have simply allocated an equal percentage of the company's profits and losses to each of the business's original members. You might not even have chosen to enter percentages in your legal operating agreement knowing that the default rule would automatically allocate equal percentages to each member. Now that your company is bigger, it is time to convert your LLC operating agreement to express each member's share in units of membership interest. This will make it a lot easier to switch over to a corporation, if you decide to do so in the future.

When LLCs move from a member-managed to a manager-managed structure, they impose a hierarchy on the company. Another way to determine hierarchy is to decide who the company's voting and non-voting members will be. As state laws do not generally spell out the rights and obligations of non-voting members, businesses need to amend their LLC operating agreement to make these roles clear.

You may want to stipulate that only the managerial class can vote on operations and business decisions. At the same time, you may want non-voting members to be able to hold a set number of units of membership so that they receive a percentage of profits and losses and the proceeds of any liquidation or company acquisition. Making these things clear in your LLC operating agreement will prevent conflict over voting rights and who gets a say in the important issues your company faces.

When businesses first start, there typically is not that much at stake if a member decides to leave without warning, and the default LLC rule (that a member can withdraw at any time so long as they provide the other members with a 30-day notice) may be enough. As companies grow, however, the untimely departure of an important member can really hurt a company's ability to earn revenue or have enough capital to continue moving forward.

You may want to amend your company's LLC operating agreement to specify conditions under which members cannot withdraw. That way, even if the member leaves, they may be liable if their withdrawal violates the terms of the operating agreement.

One way that LLCs can mitigate the damage when members withdraw their interest voluntarily is by stipulating that voting members cannot leave without selling their shares back to other members or to the company itself.

Other restrictions to the transfer of shares that any growing company should consider including in an LLC operating agreement amendment are as follows:

  • If voting members transfer shares to family members in their will, the shares must convert to non-voting after their death.
  • Members cannot sell their shares on the open market before offering other members "the first right of refusal."
  • Owners of non-voting shares should notify you when they transfer their shares.

When companies form from working collaborations between close friends, business sense sometimes gives way to personal loyalty. When you sat down to complete the first agreement, you may have decided that it would look distrustful to include the requirement that members maintain confidentiality and not engage in competitive businesses on the side.

Non-compete provisions, however, are crucial to protect trade secrets in growing businesses. Your LLC operating agreement must be amended to ensure that any members who become managers in the future act in good faith.

When the company is small, it is hard to imagine the time will come when new members, who have not even started working with you yet, push aggressively for a merger that will diminish your ability to control the company's direction. You probably thought your state's default rule was good enough.

As the business grows, however, it is wise to consider amending the operating agreement to make it harder for members to vote on big events. Ironically, this is an amendment you have to catch at just the right moment. If you already have voting members who do not agree with where the company is headed, you may have difficulty getting the super-majority vote you need to amend the LLC operating agreement. This is a good argument for revisiting your operating agreement regularly in order to make sure the rules reflect your company's short- and long-term strategic plan.

A company's original operating agreement should explain how members can add investments to the business. The process can be as simple as writing a check, and in a company's early days, that was probably all there was to it.

Problems arise when your operating agreement does not set forth a consistent process by which all members are held accountable to investments. There is no safeguard to protect those members who commit to the investment in the case where others fail to follow through. In order to avoid lawsuits, it is a good idea to amend the operating agreement in order to address scenarios like these.

According to Cliff Ennico, the host of the PBS television series Money Hunt, fledgling LLCs should use a strict mathematical formula when valuing a company in order to determine a member's buyout share. However, as a company grows, "multiples of sales and earnings may no longer reflect the true market value of the company. Some high-tech companies," Ennico points out, "have recently paid billions to acquire startups that did not even have revenue yet, much less profit!"

In the event that you need to repurchase a withdrawing member's shares in the company, Ennico recommends hiring an independent appraiser selected by the managers. Your LLC operating agreement should be revised to reflect this strategy so that members do not balk at the high price of achieving an accurate valuation.

When All Is Said and Done…

These are the main areas a growing company should look at when seeking to amend their LLC operating agreement. It may seem like a lot of information to digest, but most of the changes make good common sense. You worked hard to establish the company, and amending the operating agreement gives you some protection over the outcome. These changes help you to:

  • maintain a controlling interest in the business;
  • allow you to develop a hierarchical structure that facilitates future growth
  • ensure that your creative property remains confidential; and
  • clarify how you will keep voting shares in the company.

It is also important to remember that amending the agreement is not a one-time task. Your company will continue to grow in ways that may be hard to predict, and it is a good idea to review the LLC operating agreement regularly, looking for ways to make your business run more efficiently. Remaining vigilant about the rules and regulations that govern how your company operates is not only integral to having a successful business; it helps to ensure that your business is run ethically as well.

How to Create a LLC Operating Agreement Amendment

Use our LLC operating agreement amendment template to alter your LLC operating agreement quickly and easily.