Not taking proper care of the organizational documents for an LLC is one of the major reasons investors, founders, and managers face issues later on. Many feel that executing a template or short-form agreement puts them ahead of the pack. In reality, these generic agreements can lock in disadvantageous positions.
Below is a quick list of questions to measure how well that Operating Agreement will work for you in rocky times.
Before you take pen to paper to fix the items yourself, remember that these are just some of the issues we’ve run into, which come from outdated, poorly drafted language that is not tailored for an owner’s specific objectives. Save yourself the time and risk by working with a competent attorney who will craft an agreement based upon your specific interests.
1. Can one member hold up dissolution or your withdrawal as a member if the company falls stagnant? Many stock agreements only allow dissolution or withdrawal if agreed to by all voting members. If a business falls stagnant or fails to operate because of deadlock between the owners, then one member can use this as leverage and refuse to dissolve and refuse to let you withdraw. Some states allow for judicial dissolution by filing a lawsuit, which likely will end up being more expensive, and offering fewer options for dissolving, than if you had invested in a well-drafted agreement from the start.
Follow up item with your attorney: figuring out an appropriate, tested method for determining the strike point and handling the change in a manner fair to all parties.
2. Is a competent “Tax Matters Partner” identified in the schedules? Generally, the IRS views all members as bearing responsibility for ensuring the filing of an LLC’s tax return. Showing that a competent Tax Matters Partner was selected from the outset can help innocent members avoid late filing penalties when someone accidentally forgets to file the business return, refuses to issue K-1s to equity holders, or wrongly claims a business return isn’t required at all.
Follow up item with your attorney: figuring out how to minimize risks to a Tax Matters Partner unskilled in financial matters.
3. Do you have a schedule detailing the capital contributed by each member, the form, and its value? This schedule is used for establishing the initial capital accounts of each member, and rebuffs claims of undercapitalization when others attempt to pierce the “corporate veil.” It also carries important tax implications when filing business tax returns.
Follow up item with your attorney: how using loans in lieu of capital contributions, and giving preference to return of capital over distribution of profits can undermine efforts to prevent veil piercing.
4. Do your membership interests allow a voting block to create deadlock? Usually, this occurs when actions pass through a simple majority vote and voting percentages are evenly split in a way that creates a 50/50 block. It can also occur if a voting block prevents passage for a supermajority measure. Either way, an experienced business lawyer can show you how to craft an operating agreement in a way that divides ultimate decision-making on key issues among the members.
5. Did some members receive “sweat equity” or equity in exchange for a loan, equipment, services, land or other non-cash contribution? A well crafted operating agreement usually accounts for non-cash capital contributions through a separate agreement annexed as a schedule to the operating agreement. When working with original members, loans in exchange for equity should be evidenced through a promissory note, “sweat equity” through a services agreement, and equipment or land through equally appropriate documentation. Foregoing these additional agreements puts your business at risk.
Follow up item with your attorney: incorporating appropriate consequences for active founders who prematurely abandon the business while remaining founders continue.
These issues are common when working from a generic document, or when accepting a document provided by a lawyer (usually in a packet of other template agreements) without understanding and discussing the implications of each of the provisions.
It’s your business! Make the effort to be involved.
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