Business Law

Capital Contribution Clause of an Operating Agreement

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The LLC, or Limited Liability Company, is a unique business entity that has many financial and social benefits. Falling somewhere between a general partnership and a more formal corporation, the LLC creates a layer of protection for individual members and offers great tax incentives. For these reasons, an LLC is a common way to structure small businesses. All LLCs need a strong operating agreement drafted with a specific understanding of small business needs. This contractual foundation is especially important for budding entrepreneurs: while small businesses account for close to 50% of U.S. economic activity, nearly half fail within their first five years. A well-drafted contract can mitigate some of the issues that new companies face, protecting them in their vulnerable start-up years. 

An operating agreement is used by members or managers of an LLC. Members and Managers will have an operating agreement in place to ensure that all of the rules are followed and that everyone understands how the company will proceed. One of the reasons the operating agreement or limited liability company document is so effective is that it is a creature of contract. Except for a few statutory and modifiable rules, the drafter gets to design the majority of the rules. The drafter determines the rules, and the entire company follows and abides by them.

One of the most important sections in the operating agreement is the capital contribution section. A capital contribution section usually addresses what happens if members fail to contribute their portion of the initial start-up capital. This section also addresses what happens if a member wants to withdrawal their capital contributions, ownership of the assets in the company and whether or not the company can require additional contributions.

Many clients want the ability to pull out money from their capital contributions. This can become a problem especially in this case, where you have a large group of people coming together to pool funds for a common purpose. If a member can simply withdraw money at any time, it makes it difficult for the company’s management to make decisions on its behalf and decide whether or not to, for example, purchasing real property. Management must then consider if the company can make such a significant financial commitment if members have the ability to constantly move funds in and out?

Another reason the capital contribution section is important is if we have a member who finds themself in court and is found to be negligent and therefore owes money to a judgment creditor. Maybe a charging order has been issued against their membership distributions. A clever lawyer might say that the member can pull out their capital contributions in the form of distribution. But in this case, if you have protection in your operating agreement which explicitly states that members or managers don’t have the authority to pull that money the judgment debtor can find themselves in a better position.

It is important to state in the operating agreement that all assets acquired by the company should be in the company name. This is to ensure that there is no dispute over the ownership of an asset especially if there are many assets collected by the company and multiple members. This is usually done by either acquiring title in the name of the LLC or transferring title to the LLC shortly after purchase. Other times, an asset might be part of the capital contribution, if so, it is important to have clear ownership lines drawn 

Finally, the additional capital contribution clause is one that the drafter should make sure not to overlook. It is crucial for the drafter to understand each member’s financial position and ability to contribute additional funds should the need arise. If the drafter decides that the additional contribution clause is going to allow for members or managers to request more contributions there should be a limit on the total capital contribution amount that can be requested in a certain period of time. 

This e-bulletin was prepared by Keaton Frieberg, Esq. of Texas Suits Corporate and Courtroom Lawyers in San Antonio, Texas,

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