What is an Operating Agreement?
What businesses formed as Limited Liability Companies need is an operating agreement that spells out how members are to conduct their business, what to do in specific situations that arise, and other operational items. While generally not required in Kansas, an operating agreement is recommended to clarify responsibilities and expectations for all owners of the new entity.
Most large businesses operate under a similar type of document. It’s what a corporation’s by-laws are to a corporation, a Limited Liability Company’s operating agreement is to an LLC: it is an internal document which lays out the rights and obligations of the owners, much like the by-laws of a corporation. The operating agreement will have general operating procedures, such as when and where meetings are to be held, who will keep the books, and how decisions will be made, it may deal with dissolution and buy-outs. These topics are often more critical for smaller, closely held companies where there are few or no outside owners, and thus decisions made on a day-to-day basis do not necessarily need to be memorialized.
The operating agreement may also have a member’s buy-sell or buy-back agreement, which means that if one of the owners of the entity dies, the remaining members may ‘buy-out’ the deceased owner’s interest in the entity . All of the members will need to agree on the allocation of that percentage of ownership prior to the death.
The operating agreement may also have a shooting star plan, which means that if one of the owners of the entity dies or becomes incapacitated, the remaining members may ‘buy-back’ the deceased owner’s interest in the entity, and the deceased owner’s interest in the entity is ‘wiped-out.’ In this case, the members do not need to agree on the allocation of the ‘buy-back’ until a ‘buy-back’ is triggered.
For example, assume there are three members of the LLC – the surviving members may each, but are not required to, purchase one third of the deceased member’s interest. If the deceased owner’s equity interest in the LLC is $9,000, the surviving members would need to ‘buy-back’ the deceased member’s interest at that price. The shooting star plan may give all of the remaining members of the LLC discretion to ‘buy-back’ the deceased member’s interest or a specified number of them to ‘buy-back’ that interest.
In Kansas, having an operating agreement in place is a way to plan for those day-to-day operational issues that may come up and which can sometimes be problematic when not expressly dealt with beforehand, as is often the case. Having an operating agreement that outlines those issues will head off problems before they arise.
Do You Need an Operating Agreement for Your Kansas LLC?
While Kansas LLC law does not mandate that you have an operating agreement in place for your limited liability company, be aware that this document is the primary governing agreement that sets forth the rules and regulations of the company. Those companies that fail to draft one will be subject to state statute that outlines how all company regulations should be governed. This is particularly important if your business is a multi-member LLC; two is all it takes to establish a limited liability company under Kansas law, but if one of those people wants to leave the company or sell their stake, the rules and regulations set forth by statute will be governing factors that are not often beneficial for small businesses.
In short, without an operating agreement, you may not be protected as a member or even as an owner in the way in which you would prefer. State law includes generalizations about how an LLC is run, instead of allowing members to dictate exactly what they want. An operating agreement is a way to better plan for the long-term future of your company by allowing you to plan for issues that are sometimes hard to predict, but are bound to come up as your business continues to grow and evolve.
Essential Terms of a Kansas LLC Operating Agreement
An operating agreement for an LLC generally includes several key components:
Management structure – Kansas law allows for either a member-managed or manager-managed LLC. In a member-managed LLC, each member has the authority to operate the business. In a manager-managed LLC, the members may designate one or more managers who handle the day-to-day operations, whether or not they are members of the LLC. The operating agreement should clearly set out which type of management structure has been chosen.
Member roles – if the LLC will include members who will play various roles, such as a manager, investor, secretary or treasurer, these roles should be defined and addressed in the operating agreement. The agreement can outline the duties of each member and the time commitment required.
Voting rights – the operating agreement can allocate different voting rights to different classes of members based on their roles within the company, their investment or other factors. It can also set the percentage of members needed to approve various actions, or define what actions require just a simple majority.
Distribution of profits and losses – the operating agreement can set out how the profits and losses will be allocated among the members based on their ownership percentage. It can also specify the timing of profit distributions and outline how distributions will be made to members outside of the United States, if applicable.
The operating agreement can also address matters such as how membership interests can be transferred, how to add or remove members, how buyouts will be conducted if the operating agreement is terminated, how a judicial dissolution can be sought, and other topics.
Advantages of a Kansas LLC Operating Agreement
Operating Agreements are not required in Kansas, but can be very useful to an LLC. One of the most valuable aspects of an Operating Agreement is that it sets forth the rights and responsibilities of the members. Since the Kansas statutes are not as specific about the terms of an Operating Agreement, members have a lot of flexibility to determine how they wish to organize the business and the member relationships.
Also, the Kansas LLC statutes outline that an Operating Agreement may be amended by a majority of the members, unless the Operating Agreement states otherwise. Since a majority vote can amend the terms and conditions of the agreement, that offers some flexibility if the members wish to change the terms at some future date.
Kansas LLC statutes provide that an Operating Agreement will control over the terms of the LLC statute if it provides for a term of existence of 90 years or less. This allows the members to choose to continue the company even if the statutes would otherwise allow the company to dissolve after 90 years. The parties can expressly state that their agreement will control over other statutory provisions.
An Operating Agreement has the ability to help the LLC members avoid complicated dispute resolution procedures through well negotiated provisions in a written agreement that is custom tailored to meet the needs of those involved. The members may elect to avoid judicial interventions by providing for binding arbitration or other dispute resolution alternatives.
The Kansas LLC statute allows members and managers to limit their liability to the LLC, but managers are still subject to liability for unlawful distributions. Those limits are set out as a matter of default under the LLC statute unless the terms of an Operating Agreement state otherwise.
An Operating Agreement can encourage investment in a company by allowing members to agree on "preferred" equity distributions that may encourage investment from outside investors. The Operating Agreement may encourage new investment by allowing for liquidation and buyout procedures such that current members and incoming investors are likely to receive their return at designated intervals.
How to Create an Operating Agreement for a Kansas LLC
Drafting an operating agreement for your Kansas LLC can be a straightforward process if you follow certain guidelines and take the necessary considerations into account. Below are some practical steps to help you create an effective operating agreement.
First, when beginning the drafting process, take the time to read the KLLCA. The KLLCA serves as a default rulebook for the formation and management of your LLC. By examining the KLLCA, you can get a clearer idea of how you would like to make certain decisions and what rules you would like to override.
Next, think about the rules you would like your LLC to follow. In most cases, it is smart to cover the operating agreement basics first, which in Kansas are: 1) the name of the LLC; 2) the business’s principal address; 3) the name and address of the LLC’s registered agent; and 4) the name of each member. However, from there, you can develop a clear picture of your LLC and how you would like the business to run . For instance, you could write rules relating to purpose, management, profits, capital contributions and tax treatment for the business.
While the operating agreement can be as specific and detailed as you would like, keep in mind that you still have to keep your records under state and federal guidelines. For instance, in Kansas, an LLC’s operating agreement should be kept onsite, with the remaining records. You must also keep documentation related to each member’s capital contributions, annual reports and tax forms. However, your operating agreement is a good tool for keeping track of more informal rules and procedures.
Finally, you should always consider having an attorney review your operating agreement. While a number of free templates are available online, it may be a good thing to have a professional take a look at your agreement before submitting it to the Secretary of State. By doing so, you can be sure that you really understand the implications of every decision you’ve made.
Common Pitfalls when Creating Kansas LLC Operating Agreements
1. Failing to Have an Operating Agreement
Perhaps the most common pitfall when forming a LLC in Kansas is failing to have an Operating Agreement for the new company. Kansas law does not require an Operating Agreement, but the use of one may be vital in order to have all the roles and rules outlined for your business. Without an Operating Agreement, you will be governed by the Kansas Uniform Limited Liability Company Act. The Kansas Uniform Act can limit the protections awarded to the new members of the LLC and will not take into account any custom arrangements that the parties may agree upon.
2. Inadequate Member and Manager Rights Outlined in the Operating Agreement
Another pitfall would be if the rights of members and managers were not properly outlined in the Operating Agreement, if they were not clearly defined. If the obligations of the members or the authority of the managers are not clear, the Kansas Uniform Act will step in the gaps. This could lead to a situation where, for example, a Manager for the LLC may be attempting to bind the company to a contract that the Manager does not have the authority to do so and suddenly the Binding Contract will be binding upon the business.
3. Operating Agreement Outdated Over Time
After the LLC is formed, it is very important that the Operating Agreement is kept current. The Operating Agreement should be changed as necessary to reflect increases or decreases in ownership and ownership interest of the owners, changes in management and changes in the capital contributions owed by members. If the Operating Agreement is not kept current, and outdated information is relied upon going forward, disputes may arise in the future.
Amending and Updating Your Operating Agreement
Operating agreements are not intended to be static documents. Like the operational needs of the LLC, the terms of the operating agreements should evolve over time to reflect these changes. Amendments to the operating agreement should be made every few years, or at any sign of a material change to the business or relationships of the owners. With respect to single member LLCs, this will occur once the LLC acquires a second member. Even if no changes have occurred in the intervening period, it is a good practice to make adjustments to the operating agreement every 3 to 5 years as part of a comprehensive review of the agreements maintained by the owner’s businesses.
The process for amending an operating agreement is relatively straightforward. The amendment can be made in writing or be the result of an oral agreement. However, the effectiveness of an oral amendment may fall prey to the argument that the provision was not included to assure owners and creditors the terms of their agreement. Likewise, the failure to document an amendment will be a disadvantage in the event disputes arise regarding the changes to the terms of the operating agreement.
Notwithstanding the form of the amendment, all members have the ability to make an amendment. Older versions of the law prohibited amendments that adversely affected the rights of any member without his or her consent . However, more recent versions of the statute allow for these amendments to be made in spite of the claims of the disenfranchised member. Yet, where a member or group of members object to the amendment, sufficient opposition has been raised to queue the filing of a petition to declare the amendment invalid. Where sufficient evidence is presented to the trial court that the amendment is inequitable to those who oppose it, the amendment can be declared invalid.
In those LLCs that are governed by the articles of incorporation and bylaws, instead of an operating agreement, the process may be controlled by the documents themselves, or default rules set forth in the Kansas general incorporation and non-profit incorporation statutes. Often, the amendment of articles of incorporation and bylaws is done by unanimous consent of the organizational members. When members cannot agree, notice of the proposed amendments must be made to all persons with 10 days for an opportunity to object.
The members of the board of directors can also affect an amendment to the bylaws. Control over amendments to the bylaws can also be delegated to one or more individuals, and frequently bylaws provide the board the power to delegate the authority to amend as specified.