March 15, 2021

Here we go again. Operating agreements.

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Before I get into this month’s article, I want to thank each and every one of you for your kind comments about last month’s blog. It means the world to me that you let me honor my mentor, Mike Kennedy. Your e-mails and texts were lovely. I am so very grateful for your support.

Now on to a little smack upside the head (very Mike, by the way).

What is it with operating agreements? I thought I’d already beat this one into the ground, but apparently not.

The events below are purely hypothetical (not exactly) and reflect a conversation I rarely have with clients (actually, at least once a month and some months, once a week), and I have never, ever written a blog about this subject matter (100% false).

Client: Hi Juliet, I’d like to sell my ownership in XYZ biz. I’ve got a buyer and worked out the price. It’s all good.

Juliet: Great!! Congrats!! Remind me again of the ownership structure?

Client: Well, it’s Sally and me and a silent member who has no voting rights.

Me: No voting rights? Are you sure?

Client: Well, uh…

Me: What does your operating agreement say about transfer or sale?

Client: Um… does that really matter? The deal is done.

Me: Remember when I told you that an operating agreement was like an owner’s manual for your beautiful new LLC?

Client: Vaguely.

Me: Well, send me the operating agreement because before you do anything else we need to see what it says.

Client: Mumbling one of the following:

"I don’t think I have an operating agreement.”

“Uh-oh, we never signed it.”

“I’m sure there is nothing in there.”  (Feigned bravado.)

“Gulp." (Because they have now had a flashback to earlier negotiations with that ‘silent’ investor).

If you have an LLC and you have a silent partner, more than one partner, an investor (different blog), or minority members, please, please for the love of all that is holy, spend some money (with a lawyer) on an operating agreement. Or at least on a revision when you are up and running.

Look, you all know that I’m practical. I understand that when you start a business, you are tempted to do one of the following:

1) LegalZoom it.

2) Try to lawyer yourself by googling.

3) Borrow the operating agreement from your second cousin’s small business in North Dakota.

But suppose you survive year one and build a viable business. You must spend the cash and have the operating agreement you cobbled together, or ordered online for $99, reviewed by a professional.

Why? Because as much as I understand you are disinclined to spend money on lawyers out of the gate, your crummy starter operating agreement is going to hurt you down the road.

How so, you ask?

Let’s take the above scenario. Turns out there’s a clause to prevent a minority member from holding up a sale to a third party. It’s called a drag-along provision, which forces the reticent member to sell their units even if they don’t agree. You aren’t going to get that in a one-size-fits-all starter agreement. It is a standard provision, but whether to include it or not in an operating agreement is not typically a LegalZoom discussion. (BTW, LegalZoom does have lawyers now.) A standard operating agreement form may be okay if it’s only you, but at some point, if it’s not just you and you don’t have a drag-along provision, you cannot force that minority member to play ball.

Do you really want that minority member tanking your golden opportunity?

In addition, under the new LLC Act (not so new anymore), you don’t need member consent as a rule for the sale of a business. Old operating agreements usually default to that, so you will want to look at what your members can and should be voting on.

How about transfer provisions?

What if you want to buy out your partner and can’t because you have wacky transfer provisions (one that, for example, requires you to sell to the other members first or a certain member specifically)? What if someone wants to redeem their units (sell them back to the company) but it won’t be easy because the company doesn’t have a right of first refusal? What if your operating agreement uses terms like “super majority” but it’s not defined in the agreement and nobody ever really thought about what that meant in the big picture? What if you are at loggerheads with your partner, and you each own 50% and there is no deadlock provision that prevents the kind of stalemate in decision-making that kills a business?

And then there is valuation.

To repurpose a quote from the Rosalind Russell version of Auntie Mame: “The problem with valuation is gargantuan.”

If you are undertaking an internal sale (member to member) and have a poor operating agreement, you may not have a way to value the interest you intend to sell, or you may have a way to value it but it simply doesn’t make sense for what you are doing. Valuation (how you determine how much the units are worth at any given time) is critical. Having an operating agreement in a multi-member context without a valuation formula is just foolish.

I could go on, and on, and on but I will stop because even I’m weary of this repeated topic. 😊

Finally, if your operating agreement is truly terrible (you know I tell it like it is), it will be cheaper to just replace it. Please be open to that. It is more cost-effective to create a new agreement than to try and edit an existing bad document.

We don’t talk about price openly enough. So here is what you should expect. A good multi-member operating agreement will run you $1,200-$3,000, not just for the document itself but for the time it takes to discuss very real issues that need to be reflected in the document. With certain exceptions, I do think operating agreements can be flat fee-ed. I do this all the time. More information on flat and capped fees is in the video below.