Limited liability companies have many appealing qualities. Not least among them is flexibility regarding how governance, economic returns, allocations of profits and losses, and distributions can be structured. Subject to certain well-established rules, creative practitioners can help entrepreneurs structure limited liability companies to achieve virtually any desired business scenario. From carried interests tied to complex liquidation waterfalls to simple pro rata allocations based on percentage of ownership, a properly drafted Operating Agreement can help ensure economic expectations are clearly established and effective in practice.
With great flexibility, however, comes a grave potential to make mistakes or put into place provisions which have unintended economic consequences. This article explores some common pitfalls to avoid when drafting and negotiating operating agreements.
Poorly Drafted Management Provisions
Generally, under most state limited liability company acts, there are two types of LLC’s: (i) member managed, in which all of the members have the right to actively participate in the management of the business; and (ii) manager managed, in which one or more managers are delegated responsibility to manage the affairs of the company.
In either type of LLC, it is critical that the Operating Agreement specify how decisions are made and by whom. Often times, however, Operating Agreements either fail to address these key concepts or do so in a manner that is unclear and difficult to administer. Common pitfalls of a poorly drafted Operating Agreement include failing to: (i) specify what authority managers or members have; (ii) carve out key decisions that require a higher approval threshold (e.g., dissolution, sale of all or substantially all of the assets of the LLC, etc.); (iii) address how deadlocks in the management decisions are handled; and (iv) address how the decisions and authority of multiple managers should be handled.
At the heart of the matter, an Operating Agreement should make clear what authority the managers or members have in relation to the operation of the business. The Operating Agreement should provide clarity so everyone’s expectations are on the table going into a business and the likelihood of misunderstandings or future disputes is reduced.
Misunderstanding the Difference between Allocations and Distributions.
In order to understand how an Operating Agreement should address allocations and distributions, it is critical to understand the difference between the two. An allocation of profits and losses refers to how items of income and loss are allocated among the members for accounting and tax purposes. Conversely, a distribution refers to the distribution of property or funds from the LLC to the members. This critical distinction is often misunderstood by practitioners and clients alike.
For instance, simply because a member is allocated profits does not mean that the member actually received any distribution of funds or property. Instead, a member could be allocated profits “on paper” which would have the impact of increasing tax liability, without any receipt of funds or property equivalent to the allocated income.
To address this, it may be advisable to require minimum distributions to cover the members’ tax liabilities associated with the allocated income. It’s also important to explore when and how distributions will be made. Often times, these decisions are not addressed in depth in the Operating Agreement. While each business is unique in some respect, it is important to explore these concepts to ensure the parties’ economic expectations are clear.
Misunderstanding How Allocation and Distribution Provisions Work
While a detailed discussion of LLC allocation provisions and IRC § 704 is beyond the scope of this article, at a high level, there are two general approaches to handling allocations of profits and losses in Operating Agreements:
- a layer cake approach, in which allocations of profits and losses are made according to a series of tiers, and distributions are made in accordance with positive capital account balances; and
- a targeted allocation, pursuant to which a liquidation waterfall is established and profits and losses are allocated in accordance with a hypothetical liquidation event based on the specified waterfall.
It is important to fully understand these different approaches when drafting the allocation and distribution provisions to make sure that the intended results are achieved. When these concepts are confused or misunderstood, the economics can be vastly distorted. For instance, if an operating agreement uses a targeted allocation provision, but contains a provision liquidating in accordance with positive account balances, circularity would result rendering the agreement meaningless. When drafting an operating agreement, it is critical to understand how these two approaches work so that such an outcome is avoided.
Bad Buy-Sell, ROFR, and Drag Along Provisions
Often times, it can be beneficial to include a buy-sell provision in an operating agreement. These take many forms, which include:
- rights of first refusal, where the company or members can have the right of first refusal to purchase the interests of a member desiring to sell to a third party, subject to the same terms and conditions;
- puts, where the selling member can force the company or members to purchase their interests at a specified valuation;
- calls, where the non-selling member or company can force the sale of the non-selling member’s interests at a specified valuation; or
- drag along provisions, where the company or members can drag along non-selling members to participate in a sale of all or substantially all of the assets or membership interests of the company.
These types of provisions serve many purposes, including providing an off-ramp in the event of disputes, providing guaranties on returns, and allowing graceful exits from the business.
However, these provisions are often too general and fail to specify how the rights are invoked or how the valuation of the interests is determined. Many operating agreements provide for “fair market value” as determined by an appraiser, without any specification as to what fair market value is or guidance for the selection of the appraiser. It is also not uncommon to see provisions providing for multiple appraisals, without taking into account the delay and costs associated with such a process.
There is no one-size-fits-all approach for Buy-Sell provisions, but the key is to discuss and understand the nuts and bolts of how the provisions will operate. A properly drafted Buy-Sell should identify how it is triggered, how the valuation is determined, how disputes regarding valuation are resolved, timing of closing, and whether seller financing is permitted (and if so, the terms).
If you are choosing to do business as a limited liability company, it is critical to take the time to ensure that you have a properly drafted operating agreement. Operating Agreements form the foundation of the business, governing everything from management to economic expectations to the very purpose of the business itself. If you have any questions regarding structuring your business, please do not hesitate to contact us. We would be happy to put into place the framework that enables your business to grow and thrive for years to come.
Author: Mark D. Changaris
Readers of this article should contact an attorney to obtain advice with respect to any particular legal matter. No reader, user, or browser of this site should act or refrain from acting on the basis of information on this site without first seeking legal advice from counsel in the relevant jurisdiction. Only your individual attorney can provide assurances that the information contained herein – and your interpretation of it – is applicable or appropriate to your particular situation. Use of, and access to, this website or any of the links or resources contained within the site do not create an attorney-client relationship between the reader, user, or browser and website authors, contributors, contributing law firms, or committee members and their respective employers.