Operating Agreements are drafted when business owners are aligned on their mission and focused on growth. Fundamentals to any Operating Agreement include establishing capital contributions, ownership percentages, management structure, and profit sharing. Less attention is given when drafting the sections about disassociation, withdrawal, or termination of ownership interests.
Most business owners are choosing co-owners and investors who are committed, serious and focused on long-term business growth. Most capital contributions go towards setting up the business, such as licenses, permits, leases, equipment, staff, professional fees, etc. Most owners do not want to deal with co-owners who are planning an early exit, demanding their capital contribution back when the money has already been spent.
Breaking Down Exits
Business owners are not immune to the inevitabilities of life such as death, divorce, health deterioration, relocations, bankruptcy, etc. People change. Circumstances change. Operating Agreements are intended to streamline the procedures for these life changes; however, several fail to give structures to address these changes. Most Operating Agreements do the following:
- No voluntary withdrawals
- No procedures for forced buyouts
- Lack of value methodology for capital return
- No dispute resolution mechanisms in place
Furthermore, certain states limit the right to dissociate from an LLC or have statutory requirements not addressed in the Operating Agreement. States such as Texas or Wyoming prohibit Membership withdrawals, leaving the Operating Agreement or judicial action to resolve the issue.
Addressing Exits in the Operating Agreement
A well-drafted Operating Agreement should account for the following circumstances in light of the local state statutory requirements:
- Members choosing to leave the business early
- Irreconcilable dispute among business owners
- Death, incapacity, or divorce of a Member
- Members seeking to sell out their interest shares
- Bankruptcy or other financial insolvency issues of a Member
- Serious misconduct allegations of a Member that are detrimental to the LLC including incarceration of a Member
Each of these circumstances raises serious legal issues for the LLC that would be difficult to address with a one-size fits all general statement on member exits.
Establishing Business Valuations in the Operating Agreement
Conflicts often arise when business owners are trying to determine the actual value of their business ownership. Most Operating Agreements stick to a simple return of capital with no interest. This seems simple and straight-forward, provided that the LLC maintains the capital contributions as such. However, most businesses ebb and flow financially.
Some become significantly more profitable while others decline. Some common questions that can be resolved in the Operating Agreement are:
- Who determines the ownership value?
- What metrics are used to determine the ownership value?
- Are third-party appraisals required?
- How are disputes resolved?
- Who pays the costs for determining the value?
Without proper drafting and foresight, a Member withdrawal can be devastating to a business. Remaining business owners can lose time in negotiations or litigation and face unexpected fees over these matters.
Payment Terms Matter Just as Much as Price
Even when valuation is addressed, paying out the interest becomes problematic. Operating Agreements do not always address how these payouts will be funded. Issues of payout include:
- Whether payment is required in one lump sum or installments
- Whether interest incurs for installment plans
- Whether a security interest is granted in installment plans
Often these issues are addressed in negotiations; however, Operating Agreements or subsequent Buy-Sell Agreements can resolve these issues in advance.
Final Thoughts
Operating Agreements, with periodic review and amendments, can ensure that business owners are aligned with business owner exits. Clearly drafted provisions on owner exits can:
- Minimize disputes
- Preserve business continuity
- Protect relationships between business owners
- Provide a roadmap for difficult situations
Life changes are inevitable, but planning ahead with clearly drafted provisions on business owner exits can prevent financial strain on business owners and the LLC.
