On the Showtime series “Billions,” the main character and anti-hero, Bobby Axelrod quipped “if I can see the risk, then I can plan for it.” At a basic level, this is why people purchase insurance and retain lawyers. It is also what contingency provisions in an operating agreement are for.
Business relationships are unpredictable. History is littered with stories of allies and partners who became the most bitter of enemies. Even more common is life just happening. Regardless, an operating agreement can help add some predictability to the business journey. Similar to a primitive algorithm, the contingency provisions in an operating agreement states that if certain events occur, then it will be handled a certain way.
The following are some of the contingencies contained in an operating agreement and how they can be addressed.
VOTING RIGHTS
An operating agreement should set forth the relative rights of the members and/or managers to vote. It should also set forth the procedure for calling member/manager meetings and how votes will be counted. For example, can written consent signed by all of the members ameliorate the need for a formal meeting and vote? Is it one member, one vote? Or do the votes depend on the member’s percentage of ownership in the company?
NEW MEMBERS
Members will want to decide who can be a member and under what circumstances new members can join or exiting members can transfer their interests or leave the LLC. An operating agreement governs how new members are admitted to the LLC. Typically, members have to unanimously approve of a new member being admitted. Also, the operating agreement should address what happens to the existing membership interests once the new membership interests are issued. Pre-emptive rights provisions allow members to purchase future issuances of membership interests to protect against membership dilution.
ASSIGNMENTS
Most operating agreements restrict the ability of members to assign their rights without the consent of members and/or managers. If a member makes an unauthorized assignment or transfer of his interest in violation of the terms of the operating agreement, then they can be removed from the company. Operating agreements typically carve out exceptions for assignments that do not require the consent of other members, such as retitling members’ interests for estate planning purposes.
WITHDRAWAL
Members typically are not permitted to voluntarily withdrawal from a company. However, certain events may trigger a withdrawal, such as personal bankruptcy, insolvency, or an impermissible transfer. The operating agreement should spell out the grounds for withdrawal and the effect of withdrawal, i.e., repurchase or redemption rights on the part of the company or its members.
BUY/SELL RIGHTS
Similarly, an operating agreement should address the ability of members to purchase the interests of other members, as well as how the interests will be valued. The buy/sell agreement is typically triggered by the withdrawal of a member or an impermissible assignment. The operating agreement may call for an appraisal or some other valuation formula.
INDEMNIFICATION
The operating agreement may provide for the indemnification of members, managers, and/or officers for losses or costs relating to their respective roles in the LLC.
DISPUTE RESOLUTION
As stated above, business relationships are unpredictable. Most operating agreements provide for mediation, arbitration, and forum selection. It is very important to figure out how disputes when they arise, will be resolved and the mechanism for that to occur. Personally, I like to include a “cooling off” period before any legal action can take place.
OTHER BUSINESS ACTIVITIES
Remember in my last post where we discussed fiduciary duty? Operating agreements can limit the business activities of the members in order to prevent competition or divided loyalty. The members or investors may require that everyone work full time on the business. At the bare minimum, members may be prohibited from participating in a competing business.
DISSOLUTION & TERMINATION
Business relationships, just like personal relationships, can end for a myriad of reasons. However, unlike personal relationships, business break-ups should be as orderly as possible. An operating agreement should discuss the circumstances that may cause dissolution and the procedures to be undertaken. In the event of a dissolution, the company must “windup.” During the winding-up phase, the LLC is only permitted to engage in activities necessary to terminate the operations of the company. The operating agreement should state how debts will be paid, who files the certificate of termination, and how final distributions will occur.
CONCLUSION
Hopefully, we have shown the importance of having an operating agreement and its versatility. However, this is just operating agreements at a high level. While LLCs are easy to create, it is imperative that your company have an operating agreement and understand the contents thereof. As the saying goes, “An ounce of prevention is worth a pound of cure.”
If you are thinking of creating an LLC or would like a review of your operating agreement, contact us. We would love to help.
[Disclaimer: Nothing in this article constitutes legal advice. Please contact us in order to determine the appropriate course of action for your particular situation.]