Anatomy of an Operating Agreement Part 3: What Do I Need in an Operating Agreement to Facilitate Turnover in Ownership?

LLCs with multiple owners need to document their procedures for handling the expulsion and departure of members, as well as dissolution of the company. Without an operating agreement to define these processes, owners will be poorly able to execute these activities.

Withdrawal or Death of a Member
You may have realized that in your small business, each member is invaluable to the business and you and other members want to restrict each other from leaving the business. This is generally the case because you want to retain the expertise of each member. However, it can also be essential from a cash flow perspective because a withdrawing member may be entitled to reimbursement for his or her capital contribution and his or her share of the company. By outlining how a member can withdrawal, the remaining members can protect the business from this risk and uncertainty.

Prohibiting withdrawal altogether is unenforceable, so it is better to impose some other penalty. If the remaining members do not consent to the withdrawing member’s withdrawal, the operating agreement can assess a penalty for early withdrawal. The agreement can also provide that payout occurs over time, for example six months to a year. Thus, the business can plan its cash flow and limit the impact of a member’s departure. If all members consent to the separating member’s withdrawal, then the agreement can establish some other timeline for reimbursing the member.

In the case of the withdrawal or death of a member it is important to establish in the operating agreement how the company will be valued. Consider how to value inventory or work in progress. This can be one of the most contentious decisions so it is critical to define the valuation upfront.

Expulsion of a Member
In the instance where members wish to remove a member, it must be delineated by the operating agreement. State default rules generally do not provide for member expulsion. It may make sense in some cases to limit expulsion to the occurrence of certain events; for example, wrongful conduct or a material breach of the operating agreement. It may also make sense to require a unanimous vote, excluding the member to be removed. 

Dissolution of the Company
There are numerous obligations imposed on a dissolving company. The company must alert customers and others it has done business with that it is no longer an existing entity. Failure to properly notify can result in personal liability for company debts incurred after dissolution to the members. The company must also divide up any remaining income and assets. To alleviate the challenges with this process, it can be helpful to provide guidance in the operating agreement.

An operating agreement is an opportunity to reduce conflict in difficult times and should include provisions that will guide members through tough situations.