By Jason Watson, CPA
Posted February 22, 2020
If you are a single-member LLC or if your business partner is your spouse, this information might not apply. But if you are in business with another person, even a brother or sister-in-law, then a beefy Operating Agreement is a must have, at least eventually.
Operating Agreements are like Bylaws for an LLC, and they protect the rights of the members and define the parameters in which the members can operate. In general, attorneys do an adequate job drafting this critical document, but there are some holes that WCG feels compelled to mention.
Death, Divorce, Incapacitation
Death and divorce are easy, and attorneys have this in their templates all the time however incapacitation is often left out, or only briefly mentioned. Look at the recent Donald Sterling who was found mentally unsound and could not run his business. If your business partner is Donald Sterling who is not dead nor divorced much to LA’s chagrin, you might want a contractually obligated and legally enforceable plan to get rid of his member interest.
Do you need one doctor? Two doctors? What is the triggering threshold? Traumatic brain injuries are no laughing matter of course, but you need to protect yourself if they occur. It is not just incapacity from a mental perspective either; your business might suffer if a member cannot physically perform the role either.
Accounting, Corporate Waste
Most attorneys draft language that state any member can request a formal accounting of the expenditures and financial records, and this commonly afforded in state statutes that govern corporations and LLCs. However, they often neglect to build thresholds where all members must sign off on an expense. For example, let’s say you are a minority shareholder at 25%, and the other three members are also 25% each. Interestingly, the other three members are also a voting block since they are all family members as well. What’s to prevent them from buying a business car for someone other than you?
In Colorado we are seeing a flood of marijuana investors. This is a cash business of course and all these minority investors are pouring their savings into new pot farms. It is not a bad investment; first to market, stake your claim, build mega farms, control the pricing, etc. However, and this is a big however, it is still a cash business. Don’t you want a little assurance that the majority owner is not skimming the till?
Do you know how the IRS can determine your sales volume as a bar? They look at your purchases which is why most bars have to buy from a distributor. Determine the cost of goods purchased slap on a regional markup, and boom, you have sales regardless of what the cash deposits say. Same with divorces; we often look at lifestyle and spending to “back into” the income figures.
Oftentimes the business will have income, but no cash since it is re-investing back into the business. However, as a shareholder of an S corporation or a member of a garden variety LLC, you will pay taxes on business income and not distributions. Theoretically you could have a big tax bill based on income but never see the cash.
Another common example is when you are the minority shareholder or member. The majority elects to increase wages for themselves and not pay distributions, basically starving you out. My partner would never do that? Really. Ok. But everyone else not living in fantasy land, an Operating Agreement can protect from this situation.
Templated Operating Agreements usually have language about dispute resolution, and specifically mediation. Mediation is fine, and some courts have a standing order that parties will attend mediation prior to trial. However, mediation is not binding and parties don’t necessarily have to enter into mediation with good faith. Trials take a long time- anywhere from 12 to 24 months, just to get to opening statements.
Arbitration is like mini-court and the rules of discovery and evidence are usually more relaxed including procedure. They can be expensive since you are paying for your attorney plus the arbiter who is usually a retired judge or attorney. However, they can also be efficient.
Regardless of mediation, arbitration or trial, make sure your Operating Agreement has expeditious dispute resolution provisions, and incentives for all parties to be efficient and bargain in good faith.
So a member wants out, no problem, but what is the value of the business? Should you use a formula to determine the value? Something based on revenue? A full-blown business valuation (our retainer is $3,000 for a conclusion of value business valuation engagement)? What if you and your business partners cannot agree on the selection of the business valuation expert? Make sure there are provisions in your Operating Agreement.
As a side note, if the value cannot easily be derived from a formula, we often see language where the exiting member and the remaining members each pick a business valuation expert. Then those two experts pick a third as a neutral.
As we’ve said in the past, just because you are working with an attorney or an accountant doesn’t mean you are working with a smart person. WCG (formerly Watson CPA Group) can act as a consultant with your attorney when drafting these documents.
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