Avoiding a Common Mistake in LLC Operating Agreements

At the 2023 Kentucky Bar Association Annual Convention, Brian Dunham of Dunham Law and Andrew Bertke, CPA/PFS of Barnes Dennig presented a continuing legal education session, “Avoiding Common Mistakes in Drafting LLC Operating Agreements.” What follows is a discussion of one of the biggest drafting mistakes of the 15 that were covered in their presentation. Future posts will cover a few other drafting mistakes discussed in the presentation.

The Mistake: Not Adequately Addressing the Expectations of the Owners as to their Continuing Obligations to the LLC

Perhaps the situation we see at Dunham Law causing the largest number of serious disputes between LLC owners is where one of the owners is not fulfilling their end of the bargain (at least in the eyes of another owner), yet they still continue to receive their percentage share of the LLC profits. It can be that the owner isn’t providing the expected amount, type and level of services to the LLC. It can also be that the owner is not following through with funding their expected share of the LLC’s capital needs.

The drafting error arises when the lawyer fails to adequately flesh out the expectations of the owners in this regard, and then fails to incorporate these expectations in the LLC operating agreement. Instead, the attorney (or client itself) just takes a form, inserts the names of the owners, initial capital contributions and ownership percentages, and calls it a day.

One of the most valuable discussions when forming an LLC is the lawyer asking the owners what they expect each other to provide to the LLC - both initially and ongoing - to make the venture successful. Sometimes this discussion highlights that the owners aren’t all on the same page. Even if they’re all on the same page, the discussion reaffirms their understanding and expectations, which reduces the chance an owner reneges. It also provides the detail the lawyer needs to incorporate into the operating agreement.

Failure to Provide the Expected Services to the LLC

The typical operating agreement form does not detail services an owner is to provide to the LLC. Instead, a standard provision you see is something like, “No Member shall be required to perform services for the Company solely by virtue of being a Member.  Unless authorized with Member Approval, no Member shall perform services for the Company or be entitled to compensation for services performed for the Company.” But what if, like many businesses, the success of the LLC turns on one or more owners actually providing critical services to the LLC?

There are a couple of ways to address the requirement of an owner providing services to the LLC. One would be to make that owner a “manager” under a manager-managed form of LLC. Unlike the manager role when it is more akin to a general partner who can call all the shots in a limited partnership, this type of manager will have much more limited rights. The rights should be limited to day-to-day operations and the other owner(s) should be able remove this individual as a manager, especially if any “for cause” type of events (i.e., bad acts) occurs. The expectations of the manager should be as detailed as possible in the operating agreement - certainly going beyond the generic language found in most manager-managed operating agreement forms. Structuring the LLC in this way can also have the added benefit of causing the service-providing manager to now owe fiduciary duties of loyalty and care to the LLC.

Another way we sometimes address this situation is to refer in the operating agreement to a separate services agreement between the owner providing services and the LLC (although this owner can also serve as the “manager” with the sort of limitations mentioned in the previous section). The services agreement looks a lot like an executive employment agreement with a detailed scope of duties, performance standards, length of term, compensation for these services, termination rights, and non-competition, non-solicitation and confidentiality covenants.

However we decide to document the services to be provided, we also provide in the operating agreement that a breach of this ongoing services obligation triggers a buyout right of that owner’s interest in the LLC. If this individual is no longer providing these important services, they should no longer share in the benefits of the LLC and the LLC needs to be able to replace this individual with another owner who is willing to do so.

[Note: Often the payments to a member (i.e., an owner) for services provided to an LLC taxed as a partnership are deemed “guaranteed payments” under Internal Revenue Code section 707(c), which results in deductibility to the LLC and ordinary income to the service-providing member. However, a relatively recent change in the Internal Revenue Code known as the “Section 199A deduction” provides a 20% deduction for profit distributions but not for guaranteed payments. For this reason and others (e.g., the tax benefits of “carried interests” and consequences of the issuance of “profits interests” vs. “capital interests”), the lawyer and client should work closely with the LLC’s accountant on how these payments to the service providing member are structured and characterized.]

Failure to Provide the Agreed upon Level of Capital to the LLC

Most operating agreements provide that, in exchange for their membership interests, the “Members have contributed as initial capital the amounts set forth on Exhibit A” or something to this effect. You go to Exhibit A and see each member’s stated capital contribution is “$______” with nothing inserted. If you’re lucky you’ll see some nominal amount that is proportionate to their ownership interest (e.g., $50 for a 50% interest). As to future capital contributions, most operating agreements indicate that no one is obligated to make additional contributions, unless approved by a certain percentage of the owners or even unanimously. Unfortunately, this is how most operating agreements read, even if the members have already agreed that one or more owners will put in more money than this to fuel business operations.

The owners should have a frank discussion as to the cash that is necessary from one or more owners to give the business a reasonable chance of succeeding. The agreement as to initial and future contributions of funds should be laid out in the operating agreement in detail to decrease the likelihood that someone backs out of investing their “fair share” if the business performance doesn’t meet the best-case scenario or their personal financial situation changes.

Also, remember that capital can come into the LLC from an owner as a capital contribution or a loan. If the money is coming into the LLC as a capital contribution, the operating agreement should reflect that the money partner will not only make the agreed upon initial capital contribution, but commit to make the agreed upon additional contributions to the extent reasonably necessary to adequately fund the business operations (up to a maximum aggregate amount of course). The owners should consider how these additional contributions impact ownership percentages.

If the money is coming in as a loan, it should be reflected with a draw promissory note up to the agreed upon amount and, if applicable, be secured with a lien on assets of the business. A handy tool for this sort of scenario is what is known as a “Promissory Grid Note,” where you have a schedule attached to the note that permits you to insert the amounts of individual draws and individual repayments (vs. a specific repayment amount and repayment date). The note can be a demand note, which reqires it to be repaid within a certain period of time after demand by the loaning owner. However, it should not be permitted to be called any sooner than the period the owners agree is a reasonable for the LLC to be in a position to refinance this with a traditional lender or pay it off from profits. An exception to this would be to permit early maturity in the event of breach by the other owner or some sort of major problem or change with the company.

Whether cash is to come in as a commitment of capital contributions or loans, the operating agreement needs to include appropriate, clear and thoughtful remedies in the event of default. And just like the payment by the LLC for services provided by an owner, the LLC’s accountant should be actively involved in how the funding is characterized and documented for tax purposes.

Agreeing on Annual Budget or Plan

One underutilized tool for establishing and documenting expectations as to what the service providing member/managers and the money partners are to provide is an initial budget, or other type of plan, that is updated annually by the owners. This budget or plan should be incorporated into the operating agreement. The service providers may then be expressly permitted to take actions consistent with budget/plan, and the specific capital needs from the money partners for this same period can be established. Failure to comply with this budget or plan can trigger certain rights and obligations, such as a buyout , change in management, or loans to the LLC from a money partner coming due.

The Less Obvious Benefit of a Well Drafted Operating Agreement: Avoiding the Dispute in the First Place

Many clients think that contracts - operating agreements included - are there to formally document the agreement of the owners in the event of any lawsuit. That’s only part of the value. Many of the most heated and expensive disputes aren’t the result of someone obviously breaching the terms of an agreement. Instead, it’s the result of owners simply having different expectations as to how an undiscussed (and undocumented) scenario should playout.

The process of having the discussion about important matters, such as ongoing services and funding obligations of the owners, as part of the operating agreement process can uncover these differing expectations and avoid future, expensive disputes. Taking the additional step of documenting their agreements on these points then protects these otherwise well-intentioned owners from having, perhaps, selective memory.

Dunham Law

Dunham Law has decades of experience representing entrepreneurs and investors in structuring, negotiating and documenting business ventures and investments with others, and assisting in resolving disputes in these scenarios such as “business divorces”. Contact Brian Dunham @ 859.479.3961 or Jodi Henry @ 859.479.3964 to learn more.

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