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Are you ready to start putting together your operating agreement? This checklist with explanations details basic issues that should be addressed in a thorough and well-considered operating agreement. Not all questions will be relevant in every situation. One way of thinking about all of the issues on this checklist is to imagine the worst-case scenario–no matter how far-fetched–and then figure out how you’d want each scenario to be handled.
Once you have a basic understanding of the answers to these questions, you might be ready for the next step: drafting. However, drafting an operating agreement can be challenging and may not be the best use of a farmer’s limited time. Bring your responses to these questions to a qualified attorney. Armed with this information, he or she should be able to assemble a terrific operating agreement that is consistent with the laws of your state.
Keep in mind that your operating agreement must comply with certain baseline requirements set forth in your state’s LLC statute. Given these statutes vary from state to state, Farm Commons highly recommends that you work with an attorney to help you through the process. If you decide to draft the operating agreement yourself, you should have an attorney review it. This will help assure that all of the provisions are in line with your state’s statute and that none of the provisions contradict each other, which is sometimes hard to spot. Internal contradictions result in confusion, which can lead to disputes. This would defeat the purpose of having an operating agreement.
This checklist is designed to be used with the other resources provided in the LLC section of this Guide, including the Extensive Operating Agreement for Sun Sisters Farm, LLC and the Brief Operating Agreement for Happy Couple Farm, LLC.
□ What is everyone contributing to the business, financially?
□ How are profits and losses handled?
□ When is the decision made, and who decides whether to hand out or “distribute” profits to the members?
□ Who makes the day-to-day decisions? That is, will the LLC be manager-managed or member-managed?
□ What is the protocol for making day-to-day decisions?
□ Are there any particular roles, responsibilities or benefits of any members or managers you want to specify?
□ Will you have an annual meeting and, if so, when?
□ How are members informed about the time and place of meetings and how meetings can be conducted?
□ Who has voting rights and upon what are they based?
□ Will you allow additional members and, if so, who decides?
□ What happens if a member wants to leave, or if a member’s interest in the company is somehow passed on to someone else?
□ Who decides whether the company takes on debt?
□ Who decides whether to close the company?
□ Who decides whether existing members can make additional capital contributions?
□ Who decides on amendments to the operating agreement?
□ Who decides whether the company can change hands (i.e., be acquired or merged with another company)?
□ How are all other “big” decisions (i.e., not day-to-day decisions) made?
Another way of saying this is, what is the form and value of each member’s (the LLC term for “owners”) initial “capital contribution”? The idea is that each member brings something to the table–whether it be cash, land, equipment, past or future services, or other things that are valued as capital.
What each member offers is called a capital contribution. It is important to determine upfront and put in writing the form and value of each member’s capital contribution for a number of reasons. First, the LLC needs to be adequately capitalized to be legally legitimate. What is considered adequate will depend on your business. A basic rule of thumb is that you need enough to pay the bills as they come due. Also, the value placed on the capital contribution of each member will coincide with his or her ownership share or “percentage interest” in the company. The percentage interest breakdown may have significant implications as we’ll discuss throughout this checklist, such as how profits and losses are dealt with and what voting rights are based on.
Keep in mind that once capital is offered to the company, it is no longer considered a personal asset. It is now a company asset and the member has no right to get the capital back or to expect anything in exchange for it. This is what makes a capital contribution different than a loan, lease, or sale of land or equipment. In effect, members are liable for the LLC’s debts only to the extent or amount that each has contributed to the LLC. It’s each member’s “stake” in the business.
Unlike corporations, LLCs have flexibility in allocating and distributing profits and losses. Profits and losses are revenue minus expenses. If you have more coming in than going out, you have a profit. If you have less coming in than going out, you have a loss. The LLC is required to establish how profits and losses are allocated to the members for tax purposes. The allocation of profits and losses will affect the tax basis on each member’s individual tax return.
Profit and loss allocation could be based on the percentage interest breakdown, equal distribution (i.e., if there are three members, each gets one-third allocation regardless of percentage interest), or some other determinant. A member may want to allocate losses in a unique way to lower their tax basis. Farm Commons strongly recommends that you seek the guidance of your accountant or tax attorney if you want to allocate profits and losses on something other than the percentage interest.
A distribution is when the LLC actually gives members money or property based on profits. This is more akin to a dividend to shareholders in a corporation and is different than a salary or wage.
What is your preferred timing for making distributions?
Typically, the decision is made annually based on year-end accounting. However, you could choose to allow to decide more or less frequently (e.g., every six months or every two years).
How is the decision made?
You could require unanimous consent of all members, a supermajority or a simple majority vote. See more below on voting and decision-making options. Or, you could specify that profits will be distributed only if the company has cash reserves above a certain amount. Some LLCs choose to place a high threshold on the decision to distribute profits, particularly early on, as they feel it is important to reinvest profits back into the company. Believe it or not, the distribution of profits is the source of a lot of internal battles in companies.
Story of Sun Sisters Farm, LLC Article 3 of the Extensive Operating Agreement for Sun Sisters Farm, LLC requires just a majority consent before making a distribution of profit. The story that accompanies this sample operating agreement illustrates how touchy of a topic this can be. One of the members, Marie, prefers to keep the profits in the business. However, she holds less than a majority percentage interest and gets out-voted by the other members.
It’s best to determine upfront what is ideal for the timing and process of distribution of profits and to put it in writing. This way everyone will know what to expect. Also keep in mind that state statutes generally prohibit distributions if doing so would jeopardize the company’s ability to pay its bills.
Another way of saying this is, will the entity be “member-managed” or “manager- managed”? Most states have a default rule that the LLC is managed by its members unless otherwise provided for in the operating agreement. If you have just a few members, you’ll want to keep the day-to-day decisions and operations of the company in the hands of the members.
However, management issues can get rather cumbersome if you have many members, or just a few members with very diverse interests. A manager-managed structure addresses this by allowing you to designate a certain person or group of people as managers of the company. The manager(s) could be members or non- members–it’s up to you to decide the parameters.
The Extensive Operating Agreement for Sun Sisters Farm, LLC included in this Guide provides one example of a manager-managed LLC. The annotations also include a provision for a member-managed designation. The Brief Operating Agreement for Happy Couple Farm, LLC provides an example of a family-owned, member-managed LLC.
Whether you decide to go the member-managed or manager-managed route, you still may want to include some basic guidelines on day-to-day operations in your operating agreement. Here are some questions to consider:
Spending restrictions
It is common to require two signatures from authorized members and/ or managers on checks over a certain dollar amount (e.g., $1,000). This ensures that at least one other person has visibility into the farm’s spending and provides an additional safeguard against runaway spending. It’s also common to set a threshold (e.g., $4,500) for when the decision becomes a “big” decision and requires a vote by all voting members.
It’s helpful to put such key aspects of your management protocol in your operating agreement so that everyone is on the same page and to ensure accountability.
Keep in mind, the operating agreement is not the place to lay out nitty gritty details on day-to-day decisions, but is rather the overarching protocol or framework for how those decisions are made.
You may want to set forth the details regarding expectations of certain members or managers in the operating agreement itself. The specifics could include a clear description of roles and responsibilities of key members or managers, somewhat like a job description. It could also include any special benefits such as salary, housing arrangements and health benefits that you may decide to offer any managers of the LLC (if you are a manager-managed LLC).
If you decide to include such details in your operating agreement, it’s best to incorporate them as a separate appendix. This will make it far easier to make changes and updates to these nuanced issues. Otherwise, you would have to consistently amend your operating agreement for minor details. Also, you should consider the protocol and threshold (e.g., majority, supermajority or unanimous consent) for making changes to this appendix. Do you want to make it less than what’s required for amending the operating agreement itself? For more on this, see the discussion on “big” decisions below.
Another option is to create an entirely separate employment agreement that will govern all your agreements with your manager(s). Or, you could have a separate member agreement that governs any special arrangements with particular members, such as roles and responsibilities, housing arrangements, health benefits, etc. Either way, you are encouraged to think through these details at the get go and put them in writing in some form.
While state law doesn’t require it, it’s a good idea to have annual meetings for members to bring legitimacy to your company and to foster good relations with your members. Annual meetings are a perfect time to vote on “big” decisions, engage in strategic planning, and set and evaluate goals that will help your farming operation succeed. If you decide to hold annual meetings and designate a month or season for the meeting to be held, it’s important to stick to it.
Operating agreements also typically include a provision saying that in addition to the annual meeting, special meetings can be called if any big decisions need to be made. If you decide to have annual meetings or allow for special meetings, you’ll need to set clear ground rules for how your members are notified of the time and place of the meeting, as well as rules for how and where meetings are conducted.
If a member with voting rights doesn’t know that a meeting is taking place and a vote is held on an important issue, he or she could raise issue with the decision that was made. This could result in legal issues down the road.
Voting rights will come into play for significant company decisions (and could even play a role in certain day-to-day management decisions if you decide to make your LLC member-managed). The following are some questions you’ll need to answer.
What is the basis of voting rights in your company?
The default rule in most state LLC statutes is that voting rights are based on the percentage interest of the members.
Story of Sun Sisters Farm, LLC
Let’s say that the LLC has three members: Marie has a 55 percent percentage interest, Jema has a 30 percent percentage interest and Ingrid has a 15 percent percentage interest. Based on this, Marie automatically carries a majority vote even though she’s just one of three members. Together, Marie and Jema would carry a supermajority (i.e., three-quarters agreement).
You could choose to structure voting rights some other way, such as one-member, one-vote. Or perhaps you want to designate one person as having the final say on everything or on certain matters. It’s entirely up to you.
Does every member have voting rights?
You could decide to tier your membership interests so that some members have voting rights while others don’t. It may be that you have members who don’t really care how the business is run. Or, maybe you don’t want them to have a say! On the other hand, you may have members who want a say in every aspect of the company. How you structure the voting rights is entirely up to you.
“Big” decisions are typically addressed separately in the operating agreement, including specifying detailed protocols, establishing certain restrictions and setting a higher threshold for the decision-making process. A higher threshold would be unanimous consent or supermajority versus just a majority. What are the “big” decisions for your farm operation and how do you want to handle them?
The following are the typical “big” decisions that are addressed separately in operating agreements. You may have others that are unique to your farming operation. Again, one way of thinking about these issues is to imagine the worst- case scenario–no matter how far-fetched–and to then figure out how you’d want each scenario to be handled. Keep in mind that requiring unanimous consent protects initial founding members and safeguards their vision for how the company operates if additional members are added. However, it may be challenging to reach unanimous consent if you have many or even just a few diverse members. Operating agreements sometimes require only that a supermajority, usually defined as members owning at least three-quarters of the company, approve “big” decisions. This may be advisable if you anticipate it will be very challenging to get everyone to agree on anything.
It’s up to you to decide and clearly outline in your operating agreement what is required for making various types of decisions–whether a unanimous consent, supermajority, majority or something else.
Sometimes owners decide upfront that they most likely will not want any additional members. This is often because they don’t want their own percentage interest in the company to be reduced or diluted. Dilution could reduce their share in profits and their voting power. However, it’s still recommended that a provision is included for a process to add new members. What if the business needs more funds? What if someone you like and trust wants to invest as a part owner? If you decide to include a provision for additional members, what is the threshold for the decision? Unanimous consent, majority, supermajority or something else?
A member’s desire to leave or to transfer his or her interest in the company to someone else (voluntarily or involuntarily) will inevitably raise several issues. Voluntary transfers refer to the scenario when a member wants to leave and sell their interest to someone else. Involuntary transfers include events like a member’s death or default on a loan if the member listed their interest in the LLC as collateral. These scenarios are all considered “transfers” in LLC-speak. You should consider them all carefully and set forth detailed parameters in your operating agreement. Here are some guiding questions:
For some creative ideas on how to address decisions and issues related to transfers, read through Article 6 of the Extensive Operating Agreement for Sun Sisters Farm, LLC and the accompanying story. This sample operating agreement includes a right-of-first-refusal protocol that applies if a member wants to leave and transfer their interest to a non-member. The departing member has to first make an offer to existing members to give them the option to buy the departing member’s interest. This is just one way to address this issue and it may or may not be the best option for your farming operation. Either way, carefully think through the line of questions above to help you develop the right transfer provisions for your farm business.
Taking on debt will obviously impact the company’s financials. It will also ultimately affect the tax basis and overall interest of each member in the farm operation. Again, each member is liable up to their capital contribution. So, taking on debt puts them at risk. It’s very important to set parameters for how decisions involving debt are made.
Closing the business–or dissolution and winding up in LLC-speak–is obviously a big decision. Some members may be more optimistic than others and want to keep going if it no longer makes sense to keep the business running for whatever reason. Others may have a low tolerance for risk. Who decides whether and when to close the business? What is the threshold for making this decision? Unanimous consent, supermajority, majority or something else?
You may need additional capital to address cash flow issues or to purchase equipment or land that the business needs to grow. While you could take out loans, another option is to seek additional capital contributions from members. However, this may change the percentage interest breakdown of the company. What’s the threshold for making this decision? Unanimous consent, supermajority majority or something else?
The operating agreement controls how the business runs. Amending the operating agreement can, in effect, change everything. What is the threshold for making this decision? Unanimous consent, supermajority majority or something else?
The possibility could arise that someone or another company presents an offer to buy the farming business. While to some members it may seem like an offer you can’t refuse, to others it may be that the company has sentimental value to them and no amount of money would be enough to sell it. Even if you think it’s far- fetched, it’s important to set a threshold for decisions regarding a merger or acquisition in your operating agreement, as one never knows. What’s the threshold for making this decision? Unanimous consent, supermajority, majority or something else?
Typically operating agreements have a default clause for decisions that are not specifically addressed in the operating agreement. Here are some questions to think about concerning other decisions not addressed in this checklist:
The more you think through this now, the more your unique interests will be protected in the long run.
The intention of this checklist is to get you thinking about how you want to structure your LLC and to address certain potential scenarios. Once you’ve answered these questions, you’ll be ready to seek an attorney who can streamline the process of drafting your operating agreement.
Once you have your operating agreement in hand, be sure to follow the document. Following the rules and procedures detailed in your operating agreement gives the business legitimacy in court. It also helps facilitate good relations with your members or partners.
You should make copies or make it available in electronic form so that every member has the agreement and can refer to it as needed. It’s a good idea to keep your operating agreement in one binder along with all meeting minutes and any amendments so that they are all readily available. This also helps prove the legitimacy of your LLC by showing you are taking the separate entity seriously. Whenever you have a doubt about what’s required for making a decision or how to deal with a specific scenario when it arises, refer to your operating agreement for guidance.
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