Choosing the right form of business entity is an important and critical decision for any entrepreneur. A sole proprietorship or partnership is easy to form, and each has low administration costs, but they offer no meaningful liability protection for the entrepreneur. A corporation can provide limited liability and often this is the preferred entity for outside investors. However, with typical “c-corporations,” an exit transaction may result in “double-taxation,” with tax at both the entity and then the shareholder level, as sale proceeds are distributed. For some businesses, LLCs offer the best of both worlds – limited liability and one-level, pass-through taxation. The key to taking full advantage of the LLC as a form of entity is drafting an effective operating agreement. Here are five things to consider when drafting the operating agreement for your LLC.
- Member-managed or Manager-managed? When creating an LLC, you need to determine what the management structure will look like. Do you want a centralized management system with a Board of Managers making the major decisions of the company or would you rather have a member-managed company where all members are entitled to vote? There is no “one size fits all” approach and you need to weigh multiple factors when making your decision because it carries important implications based on which organizing jurisdiction (typically Delaware or Massachusetts) you choose for the LLC.
- How will you attract talent? Many early-stage companies want to attract talent and may not yet be in the position to compete with established companies from a salary standpoint. Therefore, you will likely need to establish attractive equity compensation packages to bring in and retain employees. Employees of corporations are used to receiving equity in the form of shares or stock options. For LLCs, equity grants typically are in the form of “profits interests” and/or “capital interests” if they are provided for in the operating agreement. You will also want to consider whether and how the interests will be subject to any vesting restrictions.
- Do you plan on raising money from outside investors? You’ll need to keep your financing strategy in mind as you are drafting the operating agreement. Unlike the “typical” common and preferred stock rights in a corporation, equity or membership units in an LLC are not self-defining or “standard” from the perspective of potential investors. The operating agreement will need to address the different investor concerns about, among other things, board seats, liquidation preferences, anti-dilution and any preemptive rights. Investors may insist on significantly more input on the specific terms of the operating agreement than they might otherwise if the business had been formed as a corporation.
- How will you deal with distributions? Perhaps the most important provision of any operating agreement—for both employee/members and outside investors—will be the distribution provisions. Because the LLC is a “pass-through” entity, most operating agreements provide for distributions to allow members to pay their annual taxes. Decisions about whether and how other distributions might be made: (i) from regular operating profits and (ii) on a sale of the company, vary widely among companies and should be spelled out in detail in the operating agreement.
- Transferability of Interests: When drafting your operating agreement, you want to address the transferability of interests. Do you want an absolute prohibition on transfers or will you allow transfers subject to certain conditions? How much notice and to whom will it be required prior to making a transfer? Will the company have a right of first refusal? Will the other members have a right of co-sale? Bottom line is that if you do permit transfers, be sure, as a condition of the transfer, the acquirer becomes a signatory to the LLC Agreement.
The LLC may be the best choice for your new business because it allows for limited liability, pass-through taxation, and significant flexibility in defining the overall business relationship. That flexibility also means that you’ll need to consider a variety of issues and set out details in the operating agreement as the business gets started.