Wednesday, January 25, 2012

Operating Agreements: Ten Important Provisions

If you are starting a business or have an established business and are bringing in a new partner, you need a written Operating Agreement.  In fact, the New York Limited Liability Company Law (NY LLCL) requires that an LLC have an Operating Agreement, failing which the members of the LLC are subjected to an agreement that is essentially created from the provisions of the NY LLCL. See Limited Liability Company Law 417(a).  Aside from the statutory requirement of a written agreement, you do not want an operating created from the provisions of the New York LLC law because there are discretionary provisions that the members can change, thereby addressing the particular interests of the members.  Below are ten key provisions a business should include or consider including in the Operating Agreement.

1.  Member Managed vs. Manager Managed.  If you do not specifically address whether the LLC is managed by the members or a manager then by default it is deemed managed by the members.  A member managed entity means that each of the members has management rights, and if this is not want the parties desire then it needs to be changed through the Operating Agreement -- indeed, it is unlikely that the majority member wants each member to have control authority.  The simple solution is to state in the Operating Agreement that the entity is manager-managed and then expressly state the name of the manager.

2. Having a Vote on Material Matters.  Even when the LLC is manager managed (by the majority member) the minority member(s) should try to negotiate to retain a right to veto material financial and business decisions.  The manager can still make day-to-day decisions but major issues would require approval of super majority of the members.  Among important (material) issues that typically require super-majority approval are (a) a material change in the business of the company, (b) a merger, sale of the business or significant assets, dissolution, bankruptcy or reorganization (c) transactions in excess of a certain amount, (d) amendments to the Operating Agreement, (e) incurring loans in excess of a defined amount,  (f) entering into transactions with the LLC members or officers, (g) redemption of membership interests, (h) employment or consulting agreements or increases in compensation of employees/consultant in excess of a certain amount, and (i) even admission of new members.  It is not unusual for a minority interest to demand that material issues can only be decided based on approval of a super-majority; therefore, do not assume that because you will own a small (minority) interest you are overreaching in asking for voting rights with respect to material business and financial matters.

3. The Membership Percentage Need Not Dictate Economic and Voting Rights.  If the intention is to allocate profits and losses other than based on the percentage of interests a member owns in the LLC or to create separate classes of voting rights, then define the terms in the operating agreement.  The Operating Agreement can vary the financial rights of members and create different classes of members, giving partners the flexibility to grant interests in the business that are not strictly defined by percentage of ownership. 

4. Tax Provisions.  The members can choose to include (or not to include) several significant tax provisions and elections affecting treatment of contributions of property, capital accounts, allocations and distributions and other tax issues.  These tax provisions should not be overlooked and should be discussed with an accountant as well.

5. Transfer of Membership Interests.  The Operating Agreement should address restrictions on transfer of membership interests, and will often include:

           (a) A right of first refusal giving other members the right to purchase offered interests pro rata based on a member's percentage interest in the LLC.  The right of first refusal prevents a member from selling its shares to a third party without giving the other members an opportunity to purchase the shares.  The right is as much about a chance for members to increase their ownership as it is about excluding the transfer of interests to an undesirable new partner.  If you include a right of first refusal, make sure the operating agreement clearly sets forth the procedure and time periods relating to exercise or waiver of the right.

          (b) Co-sale rights give members the right to sell a percentage of their interests along side a selling member so that a partner cannot liquidate its interests without giving other members an opportunity to sell some of their shares as well.  As with the right of first refusal, be sure to define what is necessary to meet each member's obligations under the co-sale terms.

          (c) An exception for transfers made to related parties since an operating agreement will generally require a member obtain approval of  for any transfer; however, you may not want your partner's son or husband as a partner so before agreeing to such a provision consider if transfer to a related partner is acceptable.

          (d) Although technically not a transfer, a restriction on the pledge or encumbrance of a member's interests.  The restriction prevents an involuntary transfer of a partner's interest to a lender or other lien holder that would otherwise occur if the the member defaults on its obligations to the lien holder.

Note:  The restrictions on transfer of a member's interests in an Operating Agreement boils down to the simple point that you entered into a business relationship with a partner (or partners), and you do not want a partner to hand over its interests to someone you do not know (or worse, do not like).

6.  Buy/Sell Provision.  Business partners can grow apart, their involvement or desire to be involved in the business can change, a partner can fail to meet expectations, or a number of other issues can arise whereby a partner wants to leave the business or the other partners want a partner out of the LLC.  A Buy/Sell provision will avoid the disputes, distractions, and (yes) legal costs that otherwise inevitably will arise during a business divorce.  The Buy/Sell provision should set the terms under which a the LLC or other partner can buyout a partner or a partner can require the LLC to buy its interests.  The structure and mechanisms of a Buy/Sell provision are discussed in prior posts, emphasizing the importance of clear terms as to when the provision can be invoked, how the selling interests to be valued, and the procedure for completing the transaction. See  

7.  Termination.  Include the grounds for termination/dissolution of the LLC.  Under New York law if you are a minority or equal partner in the LLC a court will not grant an application to dissolve the entity simply because you cannot "get along" with your business partner.  In fact, a dysfunctional partnership that still manages to be a successful business generally will not be dissolved by judicial decree under New York law.  Therefore, the Operating Agreement should delineate the circumstances under which dissolution of the LLC can occur, including (without limitation) a defined time period, the occurrence of a certain event, or a vote of a majority (or super-majority) of interests.  Indeed, if you include a buy/sell provision (as discussed above) and one partner wants to end the business while another does not, then there will be an avenue to address the issue through a buyout.

8. Non-Compete.  You may want to include a non-compete clause, and if so it must comply with New York law in terms of geographic scope, time and scope.

9. Dispute Resolution.  The dispute resolution clause should set forth the body that will decide any dispute (i.e., a court or arbitration), the venue (place) the matter will be tried (including not only the geographic location but, for example, in the case of an arbitration the arbitral institution), and perhaps that the losing party will be responsible for the legal fees of the prevailing party.

10. Flexibility.  The Operating Agreement is an extremely flexible document and is limited only by what is expressly prohibited or required by the NY LLCL.  As such, there are a number of other financial and control terms that can be addressed in the Operating Agreement so be sure to take advantage of this flexibility in structuring the rights and obligations of the members when drafting the Operating Agreement.

Disclaimer:  The discussions in this blog do not constitute legal advise nor create any attorney-client relationship.  You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters.

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