BawldGuy Here: Aside from the fact that I’ve been down the partnership road many times, most of the lessons learned came from the attorney writing our agreements. This post is some of Clint’s best work. Enjoy
I was speaking in Dallas when a prospective client approached me at a break and the following question and answer session transpired:
Q: “Why should I use Anderson versus a local attorney for my entity structuring?”
(Fair question and one that a person who does not know any better should ask before deciding to enter into a long distance business relationship with an attorney in Tacoma, Washington.)
A: “Not to be glib, but we are the best at what we do. We focus solely on asset protection for investors.”
Q: “Yes, but others in my local area tell me they work with investors so what makes you different?”
A: “We just don’t work with investors – we are investors. We understand the issues you face better than most because we are in the trenches putting our own deals together and yes, not all have worked out. We apply what I like to refer to as “dirt smarts” in our client planning. You may not like to hear it, but I expect problems or possible failure in every deal. My role as you advisor is to foresee the possible problems then plan accordingly. Think of it in terms of taking a daily aspirin to prevent headaches. There are no guarantees that you will never get a headache but the aspirin regimen may decrease and probably lessen the severity of any future headaches.”
Q: “Can you give me an example?”
A: “Funny you should ask…
Two weeks ago a client decided to expand his investing opportunities by partnering with three other individuals in an apartment building. The deal was straightforward. Each partner would contribute X amount of money for a corresponding membership interest in a LLC. My client was to receive a 16% interest for his contribution. The majority partner in the transaction (a 50% member) was going to serve as the LLC’s Manager and told the other Members he would have a local attorney at “a respectable firm” who is familiar with LLCs for real estate draft the operating agreement. Within a week, a 21 page operating agreement was circulated amongst the Members for review and signatures. (You can view a redacted version of the operating agreement here.) If you haven’t looked at the agreement, I suggest you do then ask yourself would you sign it? If not, why? SPOILER ALERT –Read on and I will give you 7 reasons why this agreement will end in disaster for any parties that sign it.
Problem #1: The operating agreement uses the term “Majority” when referencing certain decisions that are reserved exclusively to the members.
Issue: What membership percentage constitutes a “Majority”? Does this refer to the number of members or the amount of ownership?
Solution: Define “Majority” in the agreement to equal X percentage of the membership interests or a number of members. I told my client the agreement should define “Majority” as 75% of the membership interest or more than 2 members (assuming the LLC will not admit additional members).
Problem #2: The Members are required to contribute additional cash to the Company when requested by the Manager.
Issue: At any time the Manager could freeze any Member out of the LLC by making a request for additional capital. If a Member can not meet the capital call, his ownership will be forcibly reduced.
Solution: Capital calls are important if unexpected expenses arise and the LLC does not have sufficient reserves to meet its obligations. However, calls for additional capital should be made by the collective membership and not solely by the Manager.
Problem #3: The Manager/Management Committee is determined by the Members from time to time.
Issue: The operating agreement does not address how the Members determine who is a Manager or for that matter how to remove a Manager.
Solution: Address how the Members appoint or remove a Manager. This provision should include who is entitled to vote, i.e., the Manager being removed should not be permitted to vote.
Problem #4: The Manager/Management Committee is required to have at lest one annual meeting but the Members are not invited.
Issue: The Manager is not required to keep the Members informed about company
Solution: The Manager must report at least annually to the Membership.
Problem #5: The Manager shall have the exclusive control over the Company.
Issue: The Manager could sell or encumber the real estate without the approval of the Members.
Solution: The sale or encumbrance of any Company asset or an expenditure above $10,000 should be reserved to a vote of the Members.
Problem #6: The Manager can hire any person as the Manager determines necessary for running the Company.
Issue: The Manager could hire friends and family to work for the LLC and drain resources.
Solution: Every operating agreement should contain a provision that restricts or limits any transaction with a related party.
Problem #7: Any Member may transact business with the Company.
Issue: The Manager could set up other businesses to provide services to the Company thereby draining profits out of the company.
Solution: Restrict related parties from dealing with the Company unless a majority of the Members approve.
These are just a few of the problems inherent with this joint venture operating agreement. I told my client he signs this at his own peril. The most significant reason to have an operating agreement is to make sure that you and your co-members have established protocols and procedures for how the business is to be run. Without a detailed operating agreement the Members may be unable to settle their misunderstandings over finances and management, meaning that expectations are usually violated and the company fails.