If you have formed a Michigan Limited Liability Company (LLC) or are considering forming an LLC, you may be wondering if you need an operating agreement. Although Michigan does not legally require an operating agreement, the operating agreement is arguably the most critical document an LLC can have, and they are highly recommended for all LLCs. This blog post will discuss what an operating agreement is and some key benefits of a well-drafted agreement for your Michigan LLC.
What is an Operating Agreement?
The Michigan Limited Liability Company Act (the “Act”), Act 23 of 1993, governs the organization, duties, rights, powers, immunities, and liabilities of LLCs in Michigan. The Act defines an operating agreement as a written agreement by the member of an LLC that has 1 member, or between all of the members of an LLC that has more than 1 member, pertaining to the affairs of the LLC and the conduct of its business. MCL 450.4102(2)(r). Thus, operating agreements are important for both single-member LLCs and multi-member LLCs, and verbal operating agreements are invalid.
The operating agreement is a private document between the member(s) of an LLC. It is not filed with the State of Michigan, unlike an LLC’s Articles of Organization or Annual Report. At a minimum, an operating agreement should include provisions regarding:
- Contributions, Distributions, and Allocations
- Merger, Conversion, or Sale of the LLC
- Dissolution and Winding Up
- Dispute Resolution
- Transfers of Membership Interests (commonly referred to as Shares or Units)
Benefit #1: Flexibility
The Michigan Limited Liability Company Act is written in a way that gives LLCs maximum flexibility in structuring their business affairs. Most of the key provisions in the Act are default rules that apply if an LLC does not have an operating agreement or if the operating agreement fails to address a particular issue. In other words, a well-drafted operating agreement can modify the default rules to best suit the member of a single-member LLC or members of a multi-member LLC.
The Michigan LLC Act specifically provides more than 50 opportunities for an operating agreement to draft around the default rules. The Act signals these opportunities by using language such as:
- “By an operating agreement”
- “In accordance with an operating agreement”
- “Except as otherwise provided in an operating agreement”
- “Unless otherwise provided in an operating agreement”
- “Changed by an operating agreement”
A well-drafted operating agreement provides LLCs with the flexibility they need to grow and change, and the members can structure their affairs in a way that works best for them.
Benefit #2: Certainty
Certainty is essential in any business agreement, and a well-drafted operating agreement can provide that certainty to a Michigan LLC. As discussed above, the Michigan LLC Act has many default provisions, which is excellent for flexibility. However, these default provisions can create uncertain and unwanted outcomes. Some examples may help illustrate the importance of addressing these default rules in your operating agreement:
- Example 1: Alice contributes $250, and Bob contributes $750 to become members of a Michigan LLC. By default, if the LLC is profitable and distributes $1,000 to the members, Alice and Bob are entitled to equal shares, or $500 each. Many small business owners may think the fair result would be for Alice to receive $250 and Bob to receive $750 since that is what they contributed.
- Example 2: Again, Alice contributes $250, and Bob contributes $750 to become members of a Michigan LLC. By default, Alice and Bob are each allocated 1 vote, and most matters require a majority vote. There is a substantial risk of deadlock any time a matter is left to a 50/50 vote, which might not have been Alice and Bob’s intent in this example. Many small business owners may think the fair result would be for Alice to have a 25% vote and Bob to have a 75% vote because that correlates to their contributions. Additionally, there are situations where it is best for one member to decide.
- Example 3: Charlie, Donna, and Earl are members of a Michigan LLC. Earl later decides he no longer wants to be a member of the LLC. In Michigan, Earl can withdraw from the LLC only as provided in the operating agreement. Thus, if the LLC does not have an operating agreement or fails to address this issue, Earl does not have a right to withdraw. This creates significant problems and uncertainty for the LLC moving forward.
These are only a few of the countless issues your operating agreement should address to avoid misunderstandings and conflict down the road. An operating agreement can provide the peace of mind that comes with knowing that essential details are sorted out ahead of time.
Benefit #3: Asset Protection
Asset protection is one of the most important aspects of any business. In the event of a lawsuit or other legal action, you want to make sure that the LLC’s assets and the member’s assets are protected as much as possible. While these provisions are not mandatory, they can be extremely useful in protecting assets from seizure. The following examples can have a significant impact on your asset protection strategy:
- Member-Managed LLCs vs. Manager-Managed LLCs
- Mandatory Distributions vs. Discretionary Distributions
- Pro Rata Distributions vs. Non-Pro Rata Distributions
- Restrictions on Voluntary Transfers and Involuntary Transfers of a Membership Interest
- Indemnification Provisions
- Poison Pill Provisions
- Restrictions on Governance Rights
Most generic operating agreement templates fail to address these issues or are poorly drafted for asset protection purposes. This creates a substantial increase in liability and thus defeats the principal goal of a Limited Liability Company.
The operating agreement is the foundational document of an LLC that governs how the company conducts its business. Each state has its own Limited Liability Company Act with various default rules. If you are forming an LLC in Michigan, consult with a qualified Michigan attorney who can help you maximize the opportunities provided by the Michigan LLC Act. Never blindly use an operating agreement template online, especially if it is not tailored to Michigan law. If you have questions about how to create or amend your operating agreement, please book a free consultation.
This content is for general informational purposes only as of the date of this post, is not intended to convey legal or ethics advice, and does not establish an attorney-client relationship. Future legal developments may impact the validity or effectiveness of this content. Always consult with an attorney licensed in your state about your specific situation before relying on information found online, including this website.