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Outline of Operating Agreement

Overview of Operating Agreement Issues

The following is an overview of many of the basic questions and issues that should be addressed in the Operating Agreement for a Limited Liability Company. Contact Robert B. Baumgartner or Scott Pohlman at 703-591-4900 to discuss these issues in greater detail. Each situation is different, and your situation may involve additional issues that are not addressed below, or some of the issues below may not apply to you.

Functions of Operating Agreement. Operating Agreements allow the owners of companies to be able to control:

  • The transfer of membership interests, thereby assuring control over who will be members of the Company
  • The management of the Company;
  • The transfer of membership interests upon a member's death, disability, voluntary termination, involuntary termination and bankruptcy;
  • The method for valuation of the membership interests and payment of the purchase price;
  • Restrictions on current and ex- member activities (competing and non-competing);
  • Resolving deadlocks in management and voting; and
  • To sell the Company based upon the vote of the majority of the members (bring along and tag along rights).

Control Transfer of membership interests. The Operating Agreement can prohibit a member from transferring his/her membership interests without the consent of the other members.
The percentage of members who have to approve can be 100%, or a lower percentage.

Profit and Voting Percentages. The Operating Agreement will specify the respective percentages for each member in respect to their rights to profit and losses, and their voting rights. The profit right percentages can be different than the voting rights percentages.

Tax Treatment. The Operating Agreement can specify whether the Company will be taxed as:

  • a disregarded entity (for single member LLC's),
  • a partnership (for multi member LLC's),
  • a Sub Chapter S corporation, or
  • an Chapter C corporation.

Management of Company. The Operating Agreement can provide that:

The founding members will always be the sole managers or at least on the board of managers;
Managers (the equivalent of directors in a corporation) may have weighted voting;
Founding members will be the officers of the Company – can specify titles, but not recommended; and
The founding members will be compensated on an agreed percentage.

Purchase of membership interests upon Trigger Event. The Operating Agreement will provide for how membership interests will be purchased upon a trigger event.

Trigger events include death, disability, termination of employment (voluntary or involuntary) and bankruptcy.
Will the membership interests be purchased by the members, or the Company, in respect to each trigger event?
Is the purchase mandatory or optional for each trigger event?
How will the membership interests be valued?
How will the purchase price be paid?

Valuation of membership interests. There are several ways to value membership interests:

An agreed valuation every year. An agreed valuation may not reflect the valuation on the date of the trigger event. If the members fail or forget to complete the valuation, valuation can be by:
Formula based upon historic corporate data. Is simple and inexpensive, but may not reflect real current value (does not take into consideration the effect of the death of the member on revenue generation, or the effect of recent major positive or negative developments
Appraisal – Is more expensive, but will tend to reflect current valuation by taking into consideration all factors affecting the Company. Three appraisal system is recommended.
Board Valuation. The valuation can be performed by the Board of Members after consultation with appropriate professionals. This is simple, but may yield varying results, and is giving discretion to the Board. For small percentage members, the board of managers valuation can be used to simplify process.
Book Value is a simple alternative methodology, but may not reflect fair market value of membership interests.
You can combine methods of valuation.

Payment of Purchase Price. There are several ways to pay the Purchase Price.

Lump sum: Is used for small buyouts and when the cash flow permits or there are life insurance or disability proceeds.
Time payments: Normally, 10% is paid at closing, with:
Balance of purchase price amortized over 3, 5 or 10 years
Balance accrues interest (IRS rate recommended)
Security. If you want security for the time payments –
The time payments can be secured by member guarantees (dangerous), lien on Company assets, or holding transferred membership interests in escrow.

Purchase upon Death. The following are guidelines for purchasing the deceased person's interests.

Generally, the purchase is mandatory and, for tax purposes, should be by the remaining members, and not the Company. A purchase is by the other members allows the members to receive a stepped up basis for the purchased membership interests. This provides a significant tax advantage upon sale of Company
Life insurance may used to fund the purchase price.
Because any purchase has tax consequences, we recommend you consult with your CPA or tax advisor.

Purchase Upon Disability. Disability of a founding member may constitute a trigger event depending upon how critical the member's involvement is to the Company.

Disability for passive investors is usually not a trigger event.
For active participants in the business:
How disabled should a person be before being bought out?
Can the effect of the disability be limited through reasonable accommodations?
How long should the disability continue before constituting a trigger event (normally between 6 and 12 months)?
Should the buyout be mandatory or optional?
If optional, should the Company and disabled member have an option to require the buyout?

Purchase upon voluntary termination.

If a founding member elects to leave the Company –
Does the Company have a mandatory or optional buyout?
Should a vesting percentage be used? A vesting percentage is multiplied against the value of the membership interests to “penalize” the person from leaving. For example
Year one – 0%
Year two – 20%
Year three – 40%
Year four – 60%
Year five and after – 80%
Vesting percentages should discourage the member from leaving, but give him a means to leave and capture some of the value he added. The Company will not have insurance to pay the purchase price, so the payment schedule will adversely affect cash flow.
A longer payout schedule may be in order to protect the Company's cash flow.
Termination of member for Cause
The Operating Agreement will often allow the Company to terminate a member “for cause”.
“For Cause” should be carefully drafted to be limited to major bad acts that harm the Company (theft, fraud, felony or moral turpitude convictions that will harm the Company, abandonment)
The terminated member may be “penalized” by reducing the buyout to:
A fixed price – $500.
A percentage reduction (share value times vesting percentage times penalty percentage (50%). Any damages caused by member should be offset against the calculated purchase price.
Should any payout be over a longer period of time if over a certain amount to protect Company cash flow.

Bankruptcy. Should the filing f a bankruptcy by a member be a trigger event. If so, should the buy out obligation of the Company be a mandatory or optional. And, you also have the same issues to address concerning valuation of membership interests and period of payment.

How to Address Guarantees by Withdrawing Member. The Operating Agreement should address what obligations the Company and remaining owners will have to obtain a release of the selling member. The obligations may be different depending upon the nature of the trigger event that caused the buy out.

Capital Contributions.

Initial Capital Contributions. The Operating Agreement should specify the amount of the initial capital contributions of the members.
Additional Capital Contributions. The Operating Agreement should also address what obligations the members have to make additional capital contributions if needed of the operation or expansion of the Company. Options include:
No further obligation. However, if any member makes an additional capital contribution:
It will be repaid before distributions to other members. This may be a problem if the LLC is taxed as an S Corp.; or
It may result in an adjustment of the ownership interests based upon the relative percentage of each member's total capital account.
Mandatory. The obligation may be mandatory if approved by a super majority of the other members. The failure of a member to make the capital contribution will result in a penalty (no further distributions, or adjustments to ownership percentage, etc.)

Loans by Members. The Operating Agreement should provide for whether members have a right to make loans to the Company ( if approved by a majority or super majority of the members or managers) and, if so, the terms of such loans (interest rate, security, etc.).

Tag Along/First Refusal Rights
The Operating Agreement can provide that if the majority of the members find a buyer of their membership interests, the other members will
Have a right of to match the offer (sometimes called a right of first refusal) or, in the alternative,
Require that their membership interests be purchased also (they “tag along” with the transaction.
This type of provision allows the majority of the members to sell their membership interests in certain circumstances to third parties (and not be held hostage by minority members); and
The remaining members are protected because they can either buy those membership interests at the proposed sales price if they think selling is a mistake and the Company has a bright future, or alternatively cash out by selling to the prospective purchase.
A major question is – what percentage of the majority members have to agree to the sale to invoke the Bring Along Rights – 51%, 66%, 75% or higher?

Bring Along Rights

If:
the majority of the members want to sell their membership interests to a third party, ie, the majority members want to cash out because they think the time is right to sell –
but the purchaser will only buy their membership interest if the purchaser can acquire ALL the outstanding membership interests.
The majority members can require the minority members to sell their membership interests. This means the majority members can “bring along” the minority members.
A major question is – what percentage of the majority members have to agree to the sale to invoke the Bring Along Rights – 51%, 66%, 75% or higher?

For 50/50 ownership – Resolving Deadlocks

Deadlocks can be the death of a Company. Options to resolve deadlocks include:
Flip of coin or “rock, paper, scissors” to resolve minor disputes (under a threshold of value, i.e., $5,000)
Appointment of a trusted advisor to arbitrate issues.
Arbitration with the AAA to resolve major issues.
Push Pull. One member offers to purchase membership interests of other member. Other member can accept offer, or purchase offering member's membership interests for same purchase price.

Restrictive Covenants. The Operating Agreement may include restrictive covenants including:

Covenants not to compete (restricts the person from competing in the Company's industry for a period of time);
Covenants not to Solicit Clients – prevents the person from performing work for Company clients for a period of time;
Covenants not to Solicit Employees – prevents the person from taking Company employees to his new venture; and
Confidentiality – Protects use and disclosure of Company IP and trade secrets.

Remedies for Disputes involving the Operating Agreement. The Operating Agreement can provide for whether disputes will be resolved through mediation, arbitration or through the court system.

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