(last updated April 2021)

For a limited liability company (LLC), all members (equity owners) need to enter into an operating agreement, which contains all provisions relating to the management of the LLC, economic arrangements and restrictions on transfer. For a corporation, the shareholder agreement is the closest analogue to the operating agreement, but some of the relevant provisions are contained in other documents, like bylaws and resolutions, or in the applicable state’s corporate law statute.

An operating agreement is required for LLCs, even when there is only one member (though in that case the agreement is a simple form); for corporations, a shareholder agreement is only relevant when there are multiple shareholders.

Self-serving but correct answer: this agreement should be drafted by an attorney specializing in corporate/business law. As you’ll see in the answers to other questions below (which do not address every permutation of possible provisions), there are a lot of moving parts in these agreements, and it’s far from a fill-the-names-in-the-blanks exercise. There are form agreements available online, but unless it’s for a single-member agreement, this sort of thing really requires active back-and-forth with an attorney to tailor it appropriately.

“Shareholder” and “stockholder” are synonymous; each state has its own term for the equity owner of a corporation (for example, shareholder in New York, stockholder in Delaware). Another source of terminology confusion is in the name of agreements for corporations. Larger, venture-backed companies have a series of standard agreements – voting agreement, investors’ rights agreement, right of first refusal and co-sale agreement – that taken together cover all the ground that could be covered in a single shareholder/stockholder agreement for a smaller company.

In an LLC operating agreement, the parties have much freedom to set rules for management of the company. Often, there is a single managing member or manager, who can be an individual or another entity, or there can be a board of managers akin to a corporation’s board of directors. Even in the simple managing member/manager situation, there is the question of whether the non-managing members have any say in company affairs. The most common arrangements are no involvement at all, meaning these members have a purely economic interest, or some or all of these members have “major decision” rights, giving the members veto power over big picture company decisions like entering a new line of business or being acquired by another company.

In a corporation, shareholder/stockholder agreements will often contain provisions relating to the composition of the board of directors, for example, that a particular class of stock will have the right to appoint one or more members of the board.

Pre-emptive rights are one mechanism for existing holders to avoid having their interests in the company diluted by issuance of new interests in the future. Suppose you currently have a 5% interest in the company, and the company wishes to sell new interests to an outside investor. If the existing holders have pre-emptive rights, they would be able to buy new interests in at the same time as the new investor, on the same terms, such that they will maintain that 5% interest after the dust settles.

When a new business starts operating with the seed funding put in by its founders or outside investors, those funds may or may not be enough to get the business to the point where its later expenses can be paid for from the profits of the business. One way to pay for those expenses is to get new investment, either a loan or from new equity investors. Alternatively, when the business is set up, the initial investors can be required to commit to kick in additional funds when requested by company management. This request by the company for additional investment funds is known as a capital call. An LLC operating agreement can have a capital call provision requiring investors to put in additional funds proportionally based on the investors’ initial investment amounts. There can be a maximum amount of additional contribution that is required. These provisions often have disincentives for those investors who fail to come up with the cash when requested, such as the shortfall being treated as a loan with interest, or the defaulting investor’s equity interest being diluted disproportionately.

An operating agreement for an LLC will contain rules about the distribution of profits, if any, to the members after payment of the company’s debts and setting aside appropriate funds in the company as a reserve. The distributions can be on a particular schedule (quarterly, annually, etc.) or it can be left in the discretion of management. A distribution waterfall refers to the manner in which distributions are made when it’s not simply done in proportion to each member’s ownership interest. The waterfall structures can be quite intricate. Often, investors will receive a “preferred return,” meaning that they get a percent return on their investment, like interest, and sometimes get their investment paid back, all before the “common” equity, such as that held by management, gets any distributions. Often, in these structures, management will get a disproportionate return on the back end, known as a promote. For example, the agreement can provide that after the investors get their capital paid back plus a preferred return, management will get 30% of all subsequent distributions, with the remaining 70% split among the investors.

Public companies, which typically don’t have broad stockholder agreements, expect their shares to be regularly traded by members of the public via stock exchanges, without the companies’ awareness on a minute-by-minute basis of who owns a big chunk of their shares. Private companies, on the other hand, have a default assumption that their interests are being held by their owners, whom they know, for the long term. There are securities law reasons for this, as transfers that aren’t registered with the SEC need to qualify for an exemption, but from a business perspective, the founders of businesses typically want to maintain some control over whom they’re doing business with as co-owners. Accordingly, most stockholder and operating agreements contain a general statement that transfers are prohibited without company consent, though there are often one or more exceptions, detailed below.

A typical transfer restriction provision will have a proviso that it’s acceptable for holders to transfer their interests to a laundry list of third parties that are typically defined as “permitted transferees” – common examples are immediate family members of the holder or a trust set up by the holder for estate planning purposes. These transfers don’t pose the concern that a company might have of shares falling into the hands of a competitor or someone they otherwise distrust.

A right of first refusal or right of first offer (ROFR or ROFO, respectively) provides a mechanism for equity holders to sell their interests, despite the general transfer restriction, while giving the company and/or other holders an opportunity to purchase the interests, thereby keeping ownership “in the family.” In the ROFR scenario, there must be a third party who is first willing to buy the interests, and then the company and/or other holders have the opportunity to swoop in and make the purchase, instead of the third party, on the same terms that the third party offered. In contrast, in the ROFO scenario, the equity owner must first try to negotiate a sale to the company and/or other holders before making a sale to a third party.

A call right is when a holder, or the company itself, has the right to buy a holder’s interest, usually following some sort of trigger event, such as the holder ceasing to provide services to the company. A put right is the flip side of that, when a holder has the right to force another holder or the company to buy the interests from the holder. Whether one or both of these rights will be applicable is dependent on the circumstances, but there are certain common scenarios, for example a call right allowing buyout of interests upon death, disability or departure from the company. These buyouts can be funded by “key person” insurance obtained in advance, or sometimes they can be paid for by the purchaser over time. The agreement needs to establish a valuation procedure for all of these buyouts, typically either by an appraisal at the time of the buyout or some sort of formula based on recent company financial results.

The phrases “tag along” and “drag along” do a good job of describing the rights they represent. When a large holder is selling interests, smaller holders may be given the right to “tag along,” meaning the ability to also sell to the buyer on the same terms as the large holder. And when the controlling holders of a company determine to sell the full company to a third party, the small holders can be “dragged along” in the sale, meaning they can be forced to relinquish their interests, even if they don’t want that, though they would receive compensation for their interests on the same terms as the other holders.

Pretty dramatic name, huh? A shotgun buy-sell provision is often seen in companies with 50/50 ownership by two holders, as a means to force a divorce between the holders when they are basically deadlocked and not working well together. It’s a clever setup: one holder initiates the process by saying they want to invoke the buy-sell and stating what that holder thinks the value of each party’s interest is. Then the other holder is required to respond by either agreeing to sell to the initiating holder or buy from the initiating holder, in either case at the price stated in the initiating holder’s notice. Because holder no. 1 doesn’t know what holder no. 2 will decide, there’s an incentive for holder no. 1 to choose a fair valuation. This provision works best when both parties are each financially able to make the purchase; otherwise the initiating holder could low-ball the price, knowing the other holder won’t be in a position to elect to purchase.