Formal operating agreement is necessary before finding investors

“We set up a limited liability company last year for a tech business. There are three of us — one of us acts as ‘managing member’ and the other two only vote on important decisions. We have never had a written agreement for our business.

“A wealthy individual has indicated an interest in investing in us, and our accountant is telling us we need to ‘clean up our act’ and adopt a more formal agreement before we let this person invest in our business. Do we really have to, and if so, what exactly must we do to ‘clean up our act’?”

 

Yes, you do have to clean up your act. Investors are not looking to join families or communes. They are looking to get a return on their investment over time, and they want to know exactly where they stand. You will need to hire an attorney and put together a formal operating agreement (similar to a partnership agreement) for your LLC.

Here are some of the provisions I would put into that agreement:

  • A board of managers. When investors come on board, it’s time to separate the worker bees in the organization from the money bees. Your agreement should establish a board of managers (similar to the board of directors for a corporation) and give the board nearly dictatorial powers to run the business. The members (or owners, like shareholders in a corporation) should do as little as possible.

Your managing member can be the sole manager for starters, but it might be better to have all three of you as managers. The reality here is that the three of you are running the business as partners, and you want to preserve that. You always want to have an odd number of board members so there are no tie votes that have to be broken and lead to deadlock.

  • Three classes of equity. Right now, you have only one class of LLC membership interest. That will have to change before you bring an investor on board.

Your LLC should have at least three classes of equity: a class of voting preferred equity, a class of voting common equity and a class of nonvoting common equity (known as profits interests).

If your company liquidates, dissolves or goes out of business at some point, the holders of preferred equity get their money back before anyone else does. Your investor will probably want this class of equity. (SET ITAL) Do not (END ITAL) specify the terms of preferred equity in the agreement; leave that to be negotiated between your investor and the board of managers.

The three of you would hold voting common equity (similar to common stock in a corporation). If your company goes out of business, the three of you would split whatever is left over after the preferred equity investors get what’s coming to them.

The nonvoting common equity is for worker bees you bring on board in the future. Once you have an investor in your company, the company has a value, so anybody you give equity to in the future must either contribute cash for their equity or pay taxes on the value of the equity at the time they receive it. For example, if your investor puts $100,000 into your company and the next day you hire a programmer and give her 2 percent of the company as a sweat equity incentive, she will have a $2,000 tax liability at the end of the year.

  • Profits interest language. To avoid this result, the nonvoting common equity must be treated as a profits interest for tax purposes. This means the holder only pays taxes on any increase in the company’s value from the date she acquires it, not on her entire percentage interest in the company. Make sure your lawyer puts language in the agreement saying that all nonvoting common equity will be treated as profits interests.
  • Tag along and drag along rights. If your investor owns less than 50 percent of the company, you will need these provisions in your agreement. A “tag along” clause says that if the majority owners of the company (you) decide to sell their equity at some point, they must give the minority owners (your investor) the chance to sell their equity at the same price. A “drag along” clause is similar except that the minority owners (SET ITAL) must (END ITAL) sell their equity at the same price.
  • A preemptive rights clause (maybe). If after bringing your investor on board you decide to issue equity to another investor (or, if you are really successful, launch a venture capital round), a “preemptive rights” clause allows your investor to buy additional equity in your company at the same price you offer subsequent investors in an amount sufficient to maintain his percentage ownership in the company.

Putting this clause in the agreement will make your investor happy, but subsequent investors may not like it. I would leave it out unless your investor makes it a deal point in the negotiations.•

Cliff Ennico (crennico@gmail.com) is a syndicated columnist, author, and former host of the PBS television series “Money Hunt.” The opinions expressed in this column are those of the author.

© 2017 Clifford R. Ennico

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