LLC Operating Agreements and Succession Planning: What to Include
An LLC’s operating agreement serves as the foundation for governing the business, defining ownership rights, and outlining key decision-making...
9 min read
A well-crafted succession plan within your LLC operating agreement ensures that ownership transitions happen smoothly and without legal complications. Without a clear plan, ownership transfers may be dictated by state laws, leading to disputes, probate delays, financial strain, or even forced dissolution.
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By proactively structuring ownership transfer rules, buy-sell agreements, valuation methods, and decision-making provisions, LLC owners can control the future of their business and protect its financial stability. This guide walks you through how to integrate succession planning directly into your LLC’s operating agreement.
1. Identify Your Succession Goals and Exit Scenarios
Before drafting succession clauses, LLC members should clearly define what they want to happen when an owner exits—whether planned or unexpected.
Common Exit Scenarios to Plan For
- Retirement – A member plans to step away and transition their ownership.
- Voluntary Sale – A member wants to sell their share to another owner or external buyer.
- Death – A member’s ownership must transfer to an heir, co-owner, or another party.
- Incapacity – An owner becomes mentally or physically unable to manage their share.
- Bankruptcy or Divorce – Protects the LLC from losing control of shares in legal disputes.
LLC members should discuss whether they prefer:
- Keeping ownership within the LLC (internal buyout by remaining members).
- Allowing outside buyers (permitting sales to third parties).
- Passing ownership to heirs (family succession planning).
Pro Tip – A Strong Succession Plan Accounts for Both Planned and Unexpected Exits
A well-written succession plan isn’t just about retirement or voluntary sales—it also prepares for sudden events like death, illness, or financial hardships. Ensuring your operating agreement covers all exit scenarios prevents legal disputes and keeps the business stable.
2. Draft Ownership Transfer Rules
The most important part of a succession plan is defining how ownership can be transferred when a member exits. Without clear ownership transfer rules in the operating agreement, state laws may dictate who inherits or takes over ownership, often leading to disputes or unintended outcomes.
Example – A Business That Avoided Probate by Restricting Ownership Transfers to Active Members
A marketing agency LLC had three owners. Their operating agreement restricted ownership transfers to active members only. When one owner passed away, their heirs were not allowed to inherit voting rights. Instead, the LLC’s buy-sell agreement required the remaining members to buy out the deceased owner’s share, preventing probate delays and ensuring business continuity.
Key Ownership Transfer Considerations
- Can Ownership Be Transferred to Family Members?
- Decide whether an exiting member’s ownership can be passed to their heirs or if it must be sold to the LLC or remaining members.
- If allowed, clarify whether heirs receive voting rights or only financial distributions.
- Are Sales to External Buyers Allowed?
- Some LLCs restrict ownership to existing members only, preventing outside buyers from acquiring shares.
- If sales to third parties are permitted, consider giving existing members the right of first refusal before selling to an outsider.
- What Happens If a Member Becomes Incapacitated?
- Define whether a temporary manager can be appointed or if the member’s share must be sold.
- Specify whether the member’s power of attorney can make ownership decisions on their behalf.
- What Happens If a Member Declares Bankruptcy or Gets Divorced?
- If an owner’s interest is at risk of being transferred through a bankruptcy case or divorce settlement, decide whether the LLC has the right to repurchase their share before it goes to an outside party.
Pro Tip – Clearly Define Ownership Transfer Rules to Prevent Unwanted Business Partners
Without clear transfer rules, LLC ownership could end up in the hands of heirs, creditors, or ex-spouses—even if they have no experience running the business. Restricting ownership transfers to approved buyers or active members ensures stability.
3. Establish a Buy-Sell Agreement
A buy-sell agreement is one of the most critical components of a succession plan. It ensures that when an owner exits, their shares are transferred in a structured, predictable manner without disrupting business operations or causing financial strain.
Example – A Company That Used a Buy-Sell Agreement to Prevent Ownership Disputes
A manufacturing LLC had three co-founders. When one unexpectedly passed away, his spouse inherited his ownership interest. However, because the LLC had a buy-sell agreement in place, the remaining members were required to purchase the deceased owner’s stake at a pre-agreed valuation. This prevented a lengthy probate process and ensured that the business remained in control of its original owners.
Key Elements of a Buy-Sell Agreement
- Triggers for a Buyout
- Define when a buyout is required, such as:
- Retirement – A member voluntarily leaves the LLC.
- Death – Ownership must be transferred to remaining members or a designated heir.
- Incapacity – If an owner can no longer manage their stake, a buyout may be triggered.
- Divorce or Bankruptcy – Prevents ownership from being assigned to an ex-spouse or creditor.
- Define when a buyout is required, such as:
- Who Has the Right to Buy?
- First Right of Refusal – Existing members have the option to purchase the departing owner’s shares before an external buyer.
- Mandatory Buyout – Requires remaining members to purchase an exiting member’s interest, ensuring the LLC stays under internal control.
- External Sale Option – Specifies whether an owner can sell their stake to an outside investor if existing members decline to buy it.
- How Will the Buyout Be Funded?
- Lump-Sum Payment – The buyer (LLC or members) pays the departing owner immediately.
- Installment Plan – The buyout is structured as multiple payments over time.
- Life Insurance Funding – The LLC purchases life insurance on each member, ensuring that a payout is available if an owner dies.
- Outside Financing – The LLC or remaining owners take out a loan to fund the buyout.
Pro Tip – A Buy-Sell Agreement Protects the LLC From Financial Strain When an Owner Leaves
Without a structured buyout plan, remaining owners may not have the cash available to purchase an exiting member’s shares. Setting up life insurance funding, installment payments, or external financing options ensures that ownership transitions don’t financially burden the business.
4. Define a Business Valuation Method
One of the biggest challenges in an ownership transition is determining a fair value for the departing owner’s share. If the LLC’s operating agreement doesn’t specify a valuation method, disputes over pricing can delay buyouts, create financial strain, or even lead to litigation.
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Key Valuation Methods to Include in Your Operating Agreement
- Asset-Based Valuation
- Calculates the business’s value by totaling all assets and subtracting liabilities.
- Works well for LLCs with significant physical assets (e.g., real estate or manufacturing businesses).
- May undervalue businesses that rely on intellectual property, brand recognition, or client contracts.
- Revenue or Earnings-Based Valuation
- Uses a multiple of annual revenue, net income, or EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization).
- Common for businesses with consistent revenue streams and strong profitability.
- Requires agreement on which multiple to apply (e.g., 3x EBITDA or 2x net profits).
- Market-Based Valuation
- Compares the LLC’s value to similar businesses that have recently sold.
- Effective in industries where market data is available, such as franchises or tech startups.
- Can be hard to apply if there are no recent comparable sales.
- Pre-Agreed Fixed Price or Annual Valuation
- LLC members agree in advance on a set price for buyouts.
- Alternatively, members may reassess the business’s value each year and update the agreement.
- Helps prevent last-minute valuation disputes.
Example – An LLC That Avoided a Pricing Dispute With a Predefined Valuation Method
A legal consulting LLC had four partners. When one decided to retire, the operating agreement required a business valuation based on 4x annual EBITDA. Because the valuation method was agreed upon in advance, there was no disagreement over pricing, allowing the buyout to proceed quickly and fairly.
Pro Tip – Setting a Clear Valuation Formula Eliminates Disputes and Ensures Fair Pricing
Without a predefined valuation method, exiting members may demand an inflated price, while remaining owners may try to undervalue the buyout. Including a valuation method in the operating agreement keeps the process fair and transparent.
5. Include Incapacity and Decision-Making Provisions
An often-overlooked part of LLC succession planning is what happens if an owner becomes incapacitated due to illness, injury, or cognitive decline. Without clear provisions in the operating agreement, the LLC could face operational disruptions, legal battles, or difficulty making important decisions.
Example – An LLC That Avoided Conflict by Defining Incapacity Rules
A financial services LLC had three partners. When one partner developed a long-term illness, the operating agreement’s incapacity clause allowed the remaining owners to take over decision-making while providing the incapacitated partner with financial distributions. Because the plan was in place, there were no legal disputes, and the business continued operating smoothly.
Key Considerations for Incapacity Provisions
- Who Can Make Decisions on Behalf of an Incapacitated Owner?
- Designate whether a power of attorney (POA) can act on behalf of an incapacitated owner.
- Specify whether the LLC’s remaining members can temporarily manage the owner’s stake until a full transition occurs.
- Avoids legal delays by ensuring someone has clear authority over business matters.
- Triggers for Removing an Incapacitated Owner From Management
- Define what qualifies as incapacity (e.g., a medical diagnosis or court ruling).
- Decide whether the incapacitated member automatically loses voting rights or retains partial decision-making power.
- Prevents confusion if an owner can no longer participate in LLC operations.
- How Will an Incapacitated Owner’s Share Be Handled?
- Specify whether the incapacitated owner’s stake must be sold or if they can retain financial interest without management rights.
- Determine whether other members must buy out the incapacitated owner’s share.
- Avoids situations where an incapacitated owner holds up important business decisions.
Pro Tip – Defining Incapacity Procedures in Advance Prevents Business Disruptions and Legal Battles
If an LLC doesn’t define incapacity rules, business operations could stall while courts decide who can act on behalf of the incapacitated owner. Including clear decision-making and buyout provisions keeps the business running efficiently.
6. Outline Dissolution and Continuation Rules
Not all LLCs will continue operating after an owner exits. Some businesses may need to dissolve if a key member leaves, while others can transition to new ownership. Clearly outlining these rules in the operating agreement ensures that remaining members know what to do when a major ownership change occurs.
Example – A Business That Successfully Transitioned Leadership Instead of Dissolving
A family-owned retail LLC had three owners, but when the eldest owner retired, the operating agreement required a unanimous vote for dissolution. Since the remaining owners wanted to continue, the agreement’s pre-set buyout terms allowed them to purchase the retiring owner’s share. This kept the LLC running smoothly without disruption.
Key Decisions to Include in Your Dissolution and Continuation Plan
- Does the LLC Automatically Dissolve if a Member Leaves?
- Some state laws require LLCs to dissolve if an owner dies or exits—unless the operating agreement states otherwise.
- Specify whether the LLC will continue or if members must vote on dissolution.
- How Will Remaining Members Decide Whether to Continue?
- If the LLC doesn’t dissolve automatically, the agreement should state:
- Whether a vote is required to continue the business.
- If so, what percentage of members must agree (majority vs. unanimous).
- How an exiting owner’s stake will be reassigned or bought out.
- If the LLC doesn’t dissolve automatically, the agreement should state:
- What Happens if Members Decide to Dissolve the LLC?
- Define how assets and liabilities will be distributed upon dissolution.
- Ensure a plan for:
- Settling outstanding debts and obligations.
- Liquidating or distributing business assets.
- Filing necessary dissolution paperwork with the state.
Pro Tip – Define Whether Your LLC Will Continue or Dissolve to Prevent Confusion
Without clear dissolution rules, an LLC may automatically shut down if an owner leaves—even if remaining members want to keep operating. Setting up structured voting and buyout processes ensures that the business transitions smoothly.
7. Review and Update Your Operating Agreement Regularly
A succession plan isn’t a one-time document—it should be updated as your business evolves. If your LLC’s operating agreement doesn’t reflect current ownership, financial structures, or legal requirements, it could create problems when an owner exits.
When Should You Update Your Succession Plan?
- New Members Join the LLC
- If new owners buy into the business, they need to be included in the succession plan to ensure a smooth transition if they leave.
- Ownership Percentages Change
- If existing members buy or sell shares, the agreement should be updated to reflect the new ownership structure.
- A Key Owner Retires, Becomes Ill, or Passes Away
- If a member retires early, suffers a medical event, or passes away, the agreement may need revisions to clarify ownership succession and buyout details.
- The Business’s Financial Status or Valuation Changes
- If the LLC has grown significantly, past valuation formulas may no longer reflect the company’s worth.
- Updating the agreement ensures buyout pricing remains fair and accurate.
- State Laws or Tax Regulations Change
- Business and tax laws can impact ownership transfers, so the agreement should be reviewed to ensure compliance and minimize tax liabilities.
How to Update Your Operating Agreement
- Review the agreement with all LLC members every two to three years or when major changes occur.
- Conduct a business valuation update to ensure that buyout terms are fair.
- Work with legal and financial advisors to ensure compliance with tax and state laws.
- Ensure that all members agree to the changes and sign the updated agreement.
Pro Tip – A Regularly Updated Succession Plan Prevents Legal and Financial Complications
An outdated operating agreement can create just as many problems as not having one at all. Keeping it current and legally sound ensures that when an owner exits, the transition is handled efficiently and fairly.
Conclusion
Writing a succession plan into your LLC’s operating agreement is essential for protecting the business from ownership disputes, financial instability, and legal complications when a member exits. Without a clear plan, an LLC may be forced to navigate probate, unexpected ownership transfers, or even dissolution.
Key Takeaways for Adding a Succession Plan to Your Operating Agreement:
- Clearly define ownership transfer rules to prevent unwanted heirs or outside buyers from taking control.
- Establish a buy-sell agreement to ensure smooth and structured buyouts when a member exits.
- Predefine a business valuation method to avoid disputes over pricing.
- Include incapacity provisions to determine who can manage an owner’s interest if they become unable to participate.
- Outline dissolution and continuation rules to clarify whether the LLC will continue or shut down after a major ownership change.
- Regularly review and update the agreement to keep it relevant as the business evolves.
A strong succession plan ensures that ownership transitions happen on your terms, rather than being dictated by state laws or unexpected events. By structuring your operating agreement with clear, enforceable provisions, you protect the business’s long-term stability and financial health.
If your LLC’s operating agreement doesn’t currently include a succession plan, now is the time to create one. Consult with a business attorney or financial advisor to draft or update your agreement, ensuring your LLC is fully prepared for any ownership transition.
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