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The Vitals of Operating Agreements

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Disclaimer: This contents of this post are for informational purposes only regarding laws and rules of Washington State only. The contents of this post may be outdated dependent on cases decided, laws enacted, or regulations put in place after publication of the post. This post does not constitute legal advice, the contents do not constitute legal advice, and you should not exclusively rely on the contents to guide you in your legal or business decisions. You should always consult with an experienced financial advisor and legal counselor to assist you in interpreting laws and effectuating your business’s intent.

What is an operating agreement?

Limited liability companies (“LLC”) are one of the most common business structures. Like corporations have by-laws, LLCs must adopt operating agreements, a document that is signed by all existing members and outlines the business structure, taxation, management authority, whether future interest transactions will constitute securities under SEC rules, membership interests, liabilities, voting rights, dispute resolution mechanisms, profit sharing rules, capital infusion obligations, registered agent, principal business location, whether you can elect out of the IRS Partnership Audit Regime (if you are classified as a partnership with the IRS for taxation purposes), and transfer restrictions on membership interests, among other things.

In the absence of a written operating agreement, the LLC will be governed by the default provisions of RCW 25.15, which may be unfavorable to your best interests and contrary to you and your members’ oral agreements or the LLC’s unwritten intent. Here are some important reasons you want to enlist the services of experienced corporate counsel to negotiate and prepare a well-thought-out and favorable operating agreement.

The LLC Won’t Be Subject to Generic Default Rules

As stated above, the failure to have a written operating agreement in place means the default rules of Chapter 25.15 RCW (LLC Act) will govern your business. These are inflexible and unlikely to be in your best interests.

Unit Interest Classifications and Voting Rights

You may elect to have different unit or interest classes and corresponding voting rights. Further, if there are minority and majority interest holders, it will outline whether their voting rights on business and managerial decisions are proportional to their interest holdings or whether unanimous consent for major business decisions is required without regard to minority or majority status or whether majority vote of the members controls. This has large implications for not just making major business decisions but whether future sales of interests constitute investment contracts and thus securities requiring registration with WA State authorities and the SEC.

Drag along and Tag Along Rights

A drag along provision allows the majority interest holders to require the minority interest holders to sell their shares. This is usually triggered in a takeover offer and forces the minority interest holders to participate in a purchase along the same terms as the sale by majority interest holders, allowing the purchaser to acquire the entire company and facilitating the entire process.

A tag along provision has the opposite effect of a drag along provision. If majority interest holders want to sell their interests to a third party buyer and don’t notify minority interest holders, the tag-along provision lets the minority interest holders participate in the sale of their own shares in accordance with the same terms set forth in the acquisition of the majority interest holders’ sale agreement. This also facilitates the entire process.

Preferred Distribution Clauses

These can take various forms. For example, perhaps a minority interest holder has put up significant money to buy into a pre-existing LLC under terms of a loan to the company. This clause would allow them to be paid first before any other distributions can be made to other interest holders. Similarly, in case of a liquidation event, this would let preferred classes of interests receive priority of distribution. This typically alleviates the propensity for disputes between the parties upon liquidation, and allows fundraising events to occur on favorable terms to all members.

Fundraising

Membership interests are typically categorized as either units or percentages. There are two ways to raise funds (and many are subject to separate SEC and Washington State regulations depending on circumstances). The first way is that the LLC’s organizers form the LLC and authorize a fixed number of initial units, say 10,000. The two initial members can acquire 5,100 of those units, preserving majority interest holder position, and reserve 4,900 of those units to bring in future members and raise funds through investment. Operating agreements should include provisions for future fundraising and whether unanimous consent of members is required or simple majority vote. Also, you would need to enlist the services of an experienced lawyer to later effectuate the intent by registering with the SEC if you intend to advertise or do public offerings or whether private events only may occur. This would require certain classes of investors and private placement memoranda to be drafted to ensure compliance with antifraud regulations of WA State and SEC laws.

How New Members May be Admitted

Similarly, the agreement should set forth how new members can be admitted, whether through secondary sales of existing interests or acquisition of non-issued new membership interests. It should dictate whether majority vote or unanimous consent is required.

Management Authority

LLCs are typically either managed by a single manager or by all of its members, as elected by the members in the operating agreement. Manager-management is good in a sense because it vests sole management authority in a single individual. This makes transactions and major business decisions easier and quicker. However, if the LLC has minority interest holders, election of manager-management could potentially mean that those minority holders are passive investors, holding investment contracts, and relying on the sweat of a third party to generate profit for them. This is gravely important because it will potentially make the interests securities, subject to a vast array of state and federal regulation requirements and antifraud provisions. Member-management, on the other hand, has its upsides and downsides. If unanimous consent is required for all major business decisions, then it slows the process. In the case of an LLC holding commercial property, then it would mean that it could lose a prospective tenant to fill a vacant space if all members don’t promptly respond to inquiries or dissent from the decision. However, it has upsides. If the LLC is member-managed, and unanimous consent of major business decisions from its members is required, then the minority members have power to exercise control, and thus do not hold investment contracts and the interests are not securities. This means that you wouldn’t have to comply with SEC or State securities laws when bringing in new members or transferring interests on the secondary market.

Dispute Resolution and Governing Law.

While we all hope that no disputes arise and that all members are in it together, the reality is that disputes occur everyday. Deals go sour. Members die or get divorced. Money is lost. Members become resentful and want an exit or worse, to sue and be recompensed. Dispute resolution clauses dictate how disputes between the members are to be handled. LLCs often want to keep their disputes out of course. We typically recommend an agreement to negotiate, mediate, and arbitration. First, the parties are required to try to settle the dispute among themselves without submitting the matter to a third-party. If they cannot agree within a set time period, then they must enlist a mediator to attempt to resolve the dispute. Mediation is non-binding on the members. Rather, an experienced business lawyer goes back and forth to the members, analyzing merits and risks of their positions, and attempts to convince them to agree to settle the dispute. This is favorable because it is cost-effective and lets the parties negotiate the terms themselves. In a last ditch effort if mediation fails, then the parties must arbitrate the dispute. Arbitration is a forum for disputes to be decided by a third-party where that third party’s decision is binding on the parties. Typically, this is submitted to the American Arbitration Association which hires retired judges and highly qualified lawyers to act as an informal judge. The process is better than court because it means less discovery, is private, and is quicker than court. However, the decision of the arbitrator is still binding on the parties. The parties can limit appeal rights and can also decide whether to submit the matter to a hearing or have the dispute resolved “on the papers,” through memoranda drafted by counsel with submitted exhibits. Typically this decision can be recorded as a judgment in any jurisdiction where the parties reside. Typically the jurisdiction is where the LLC is headquartered or does business and the governing law is the state of residence, in this case the State of Washington.

Withdrawal and/or Membership Exit or Buy-out

As stated above, members die, divorce, or become resentful. Or for other reasons they want to withdraw from the membership. It is important therefore to set forth what happens when a member dies, becomes incapacitated, or can exist the LLC. Agreements often require the other members the first right to acquire the leaving member’s interest by including exist and buy-out provisions, including procedure, valuation of interests, and payout terms. Agreeing to them now alleviates the likelihood of future disputes.

Accredited Investor, Sophisticated Investor, and Financial Status Clauses

As set forth throughout this post, sales of certain membership interests may be classified as securities. If they are not securities, you are not required to satisfy any SEC or Washington State registration requirements. If they are securities, future transactions may fall into an SEC or WA exemption. Sometimes exemptions still require registration with state or federal bodies, and sometimes they do not. The operating agreement and any purchase/sale agreement should require disclosures by the LLC or issuer as well as the purchaser. The purchaser should be required to submit financial data to the LLC and sellers, including financial statements, including net worth, assets, and liabilities. Accredited and sophisticated investors are deemed to be responsible and knowledgeable enough to evaluate risks. Unsophisticated investors are deemed to be vulnerable by state and federal regulations to be at risk of fraud and require heightened disclosures and registration. It’s important that the members memorialize their status in an investment representation clause so that the members and the LLC is protected.

Hire an Experienced Corporate and Business Lawyer

As you can see from above, there are myriad pitfalls in failing to have a well negotiated and drafted operating agreement in place. You want to run your business. You don’t want to navigate the law - that’s not what you do. You need an experienced Spokane and Washington State Corporate and Business lawyer to assist you in navigating the treacherous minefield of the LLC operating agreement. The Mayo Law Group PLLC and Mack Mayo have extensive experience in this arena, represent more than fifty corporations and LLCs operating a wide variety of businesses, and can help you in the most cost-effective manner, to maximize your profits, protect your individual assets, and minimize your risks. Schedule your no-risk, free telephone consultation to learn how we can help you with your business enterprise. You can also download our free LLC formation questionnaire to learn more about what you need to get your business formed and up and running.