Why a $30 Operating Agreement Can Cost You Thousands

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7-13-3If you want to sleep at night, get your Operating Agreement prepared properly. If you don’t care, go cheap, or don’t bother with one at all. Just remember that when you’re writing all the checks.

I get lots of clients asking me to take a look at their Operating Agreements. Some are prepared well and get the job done. Others are prepared poorly, and are missing key information. And others still are prepared so wretchedly that unsuspecting business owners could set themselves up for unexpected liability or costs.

I saw this recently with a Series LLC. This is a hot area right now. People are cottoning onto the idea that a Series LLC can be the last entity you ever need. Investors and entrepreneurs love the structure, for its ability to let you create fully formed subsidiary LLCs in minutes, each with full legal protections from the others, with the ability to be taxed separately, and with the ability to have separate ownership and management.

But to make sure the whole structure hangs together properly, you’ve got to have an agreement that is detailed enough to cover your bases. It’s got to have the framework for creating, operating and dissolving separate subsidiaries. It’s got to be clear on the powers granted exclusively to the Series Cells to deal with their own business, and that they clearly aren’t part of the main LLC unless specifically stated. It’s got to deal with tax treatment, not just for the main LLC, but for the Series Cells. It’s got to deal with the powers of the main LLC Manager versus the Series Cell Managers. It’s got to deal with ownership, rights of members and subsidiary members, and so on. And, don’t forget, each Series Cell needs its own Operating documents as well.

7-13-2I recently reviewed a Series LLC Operating Agreement that was 7 pages long and missing just about everything I’ve mentioned above. Heck, it didn’t even allow the owner to bring in partners! To me, it looked like a short agreement, specifically designed for a 1-owner LLC that had just been amended to add in a few clauses allowing it to be a Series LLC. It wasn’t even a good short agreement for a single owner LLC, let alone a Series LLC. A typical agreement for a Series LLC starts at 25+ pages and I’ve seen them go to 50 pages or more. Is there some extra legalese in there? Sure! Is it necessary? I think so, yes.

Because this is a new area of law (new is relative – Series LLCs have been around for about 14 years now) there is confusion and uncertainty. States have rushed to add Series LLC laws to their books without thinking through some of the underlying issues. And, any time that happens, lawsuit potential over the contract increases.

With an incomplete Operating Agreement, you’re at the mercy of state law. If your Operating Agreement doesn’t cover the situation or issue at hand, and state law does, you’re stuck with whatever state law says – even if it isn’t what you want. Same with a completely missing Operating Agreement. But with an incorrect Operating Agreement, you’re risking compromising your whole structure. You could find your structure collapsed into a single structure, and liability in one Series Cell tainting the others. You could have tax issues, as different businesses get mushed together. It could cost thousands in lost time, extra taxes, and legal fees to get sorted out … assuming you can sort it out at all.

Isolated heap of shredded paperAn attorney friend of mine once told me that her job was to litigate all the mistakes that contract-drafting attorneys made. As far as she was concerned, the more poorly written a contract or an agreement the better for her and her client. She loved to fine-tooth comb documents looking for things that didn’t match up, contradictions … all of the things that can happen when people don’t understand what they are drafting or don’t take the time necessary to get it right. I always keep her in mind when I’m drafting documents!

Want to learn more about how to protect yourself and create an Operating Agreement that’s good for more than just lining a bird cage? Join Diane and I on July 24th, for the teleseminar, Protecting Your LLC. You can sign up here — best of all, it’s absolutely FREE! We’ll be talking about both regular single-entity LLC Operating Agreements, plus we’ll touch on the Series LLC and some of the things you need to think about.

One Comment

  1. I could not have said this better and constantly repeat this to existing and potential clients, and anyone else who will listen. As a tax/transactional attorney, I can definitely say that some of my most lucrative assignments (and those of my litigator friends) come from dealing with a venture break-up where there is no equity agreement or a wholly inadequate equity agreement.
    I cringe when I hear this question from a prospect: “How come you will charge me $10,000 to draft my equity agreement, but the gal/guy down the street can do it for $1,000.” Answer: “Because I don’t sell forms.” And if they insist on the low-cost option, with a wink and a nod, I give them my card and urge them to buzz me if things don’t work out. Many times I do hear hear back from one or the other of the principals when “something” doesn’t work out because it was not contemplated and addressed during negotiations and structuring of the equity agreement.

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