Promoters tout the limited liability company as an excellent entity choice for new and small businesses given the flexibility associated with the structure. While generally true, the flexibility also creates traps for the unwary. One such pitfall concerns the operating agreement. Why is an operating agreement important? Let’s take a look.
State and Promoters Set Traps
“Form an LLC! LLCs are perfect for your new business!
You don’t even need an operating agreement in most states!”
So goes the marketing pitch. As with most marketing pitches, there is a certain amount of truth associated with this statement, but also a certain degree of danger. The fact is most states do not require a written operating agreement. But not forming one is a massive mistake and can cripple a business.
Bob and John are buddies. Bob has an idea for an app but needs money. Bob pitches the idea to John, who believes it is a great opportunity. John puts up $50,000 to fund the business. Bob and John agree to split ownership 50-50 and work full-time at the company. Bob and John form an LLC but do not create an operating agreement.
The company loses money the first year of operation, and John loses interest. He starts showing up only a few days a week, leaving Bob to carry the extra workload. Like a marriage going bad, matters become tense between the men. Bob and John discuss different buyout options to get John out of the business but can’t agree on a resolution. Tempers flair and the next thing anyone knows, the parties are in court accusing each other of all types of malfeasance. After a year, the court forces through a settlement that neither party is happy with, particularly given the significant legal fees involved in the litigation.
An operating agreement could’ve prevented the strife.
What Is An Operating Agreement?
An operating agreement is used to nail down a number of issues ranging from how the company will be operated on a daily basis to what occurs when a person who owns equity is bought out. Topics include:
- Voting rights,
- Distribution of profits,
- Capital requirements,
- Buyout provisions,
- Whether members can compete with the company,
- Voluntary exit provisions, and
- How the company will be taxed.
If we revisit the mess between Bob and John, a properly drafted operating agreement would have diffused much of the conflict. The operating agreement would have contained a clause detailing how a member could be bought out, the formula used to determine a price, the payment structure, and so on. Once John lost interest, Bob could’ve bought him out pursuant to the process detailed in the operating agreement instead of spending a year in court.
Still not convinced an operating agreement is necessary? Let’s look at another problem with the LLC formed by Bob and John. As friends, they’ve agreed to split everything 50-50. While such a split is fine when discussing the distribution of profits, the division causes massive problems on other issues such as voting.
Company XYZ approaches Bob and John about a joint venture. The potential partner is known to be very aggressive and push legal limits. Bob believes the risk is worth the potential profits. John does not. Do they accept the offer or not? It’s hard to say since each person has 50 percent of the voting rights, which creates a tie. In a best case scenario, Bob and John eventually talk through the matter and agree on a course of action. In a worst case scenario, the boys end up in court with a judge trying to decide the question. Even in the best case scenario, continual “tie” votes will eventually poison the relationship.
A better approach is to give Bob or John a 51 percent voting right in the operating agreement. The 51-49 percentage prevents debilitating voting ties. The flexibility of the LLC is such that the parties can still agree to distribute profits 50-50 notwithstanding the adjusted voting percentage split.
The problems Bob and John experience in this article point out one of the real advantageous aspects of an operating agreement – planning. Ideally, the agreement should be negotiated before forming the limited liability company so the parties can work through touchy subjects and come to a final agreement where everyone understands their specific rights and obligations. In doing so, most internal issues that can arise during the course of business will have already been addressed in the operating agreement preventing expensive legal battles.
I’ll admit it. I hate going to the dentist. The idea of someone half my age poking my gums and admonishing me to floss more is aggravating. In my younger, wilder days, I disliked the idea so much that I blew off regular checkups for about eight years. And chain smoked. You can guess the result. About $5,000 in crowns, a root canal, and general dental work.
I imagine you feel the same way about going to a lawyer. Not exactly high on your list, but you need to suck it up and see a lawyer when forming a business entity with other parties. In the case of an operating agreement, the language in the document is going to define what you get out of the company if it succeeds or fails. For example, I’ve seen operating agreements in the film industry that allow the majority owners to force all members to contribute additional money to the company at a future time. Surprise! You want to discover such an obligation before signing the agreement instead of three years down the line when the other members vote for a capital infusion, and you’re looking at a $25,000 bill. A lawyer can identify and contest this language and other provisions not in your best interest.
Why is an operating agreement important? The document governs the management and relationship between members of a limited liability company. Given everything on the line, you should always hire a lawyer to represent your interest in the negotiations. Yes, even if it isn’t me.
The money is well spent.
Richard A. Chapo, Esq.