A debate exists amongst parents whether going from no kids to one kid, one kid to two kids, or two kids to three or more kids is most difficult.1 In a business entity, there is no debate; the most challenging transition is going from one owner to two. Throughout our choice of entity discussion, one persistent undercurrent is how the move from one owner to multiple owners changes the equation. With multiple owners, forming an entity becomes essential and establishing the relationship between the owners becomes more than just a formality. You have to work through it.
Owners detail their relationship in (a) the state law code (Corporate Business Code2 if a corporation/ Limited Liability Corporation Act3 if a LLC/ also other code sections here for other lesser used types of companies, such as P.C. – professional corporation, RLP, etc.) and (b) the organizational documents. Organizational documents for small businesses are really where the rubber meets the road. Organizational documents supplement, amend, or modify the statutory law. Shares of a corporation, for example, can be freely transferred among people under the corporate code. Small businesses, where ownership is purposely controlled and limited, do not like this approach. Accordingly, most shareholders will amend this default provision in a buy/sell or shareholders’ agreement.
For corporations, organizational documents typically consist of Articles, By-Laws, and Shareholder or Buy/Sell Agreements. For LLCs, organizational documents typically consist of articles of formation and an operating agreement. While you can pull these off of the Internet, this is one area where I would strongly discourage you from doing so. (Actually, this is against my own pecuniary interest as some of our most lucrative legal fees have arisen from cases of companies that have pulled organizational documents off of the Internet.) It is the operating agreement for LLCs that I believe gives clients the most headaches.
My form LLC Operating Agreement is 46 pages long, single-spaced. Anyone outside the legal profession who likes to read an operating agreement immediately draws a competency red flag. It is dense and complex. Can I shorten it? Not easily. I have developed the form, as have all lawyers, over the years based on cases (known generally and particular to me), experiences, and feedback. While you can find something online, you may face repercussions in other parts of the document that do not make sense. Although lawyers will not admit this, operating agreements are built like a house of cards where one section often relies on another section. Pull one area or make an amendment, and the rest of the document falls down. Veering from the form costs time and money.
I have tried, and continue to endeavor, to fix this fundamental issue in operating agreements. I believe that if you, the layperson, cannot make sense of your legal document then it has failed in its mission to bring clarity to the relationship. In this vein, my agreement tries to use exhibits so that core terms are at the front.
However, I am currently failing in this effort. Custom, the desire for verbiage to spell out procedures, and the ability of computers to rapidly reproduce legal documents cut into the ability to create documents that clients can easily, clearly, and concisely understand. Nowhere is this truer than in an operating agreement. Operating agreements perform several functions. As a consequence, they are bulky.
Specifically, operating agreements perform four functions that make the actual operating agreements difficult to understand:
1. Tax: LLCs with multiple members are treated as partnerships. Partnership tax is usually simple, except when it is not. The flexibility in tax treatment can be extremely helpful and allow for creative tax solutions to help work through. However, in order to take advantage of this flexibility, you have to have the requisite verbiage in your operating agreement. This verbiage is extremely complicated. I have listened to the ‘shifting capital allocation’ lecture, which is the heart of the complexity, 20 times now, and I am still trying to figure it out. Most agreements are cross-referenced based on inane technical IRS mumbo jumbo. Tax lawyers get a kick out of being the only people who understand it. As a consequence, most mere mortals cannot touch any of these sections without fear of the IRS or extremely large billable hours.
2. By-law type provisions and Buy/Sell Provisions: In a corporation, meetings and corporate governance are in by-laws and rights of transfers (among owners, to third parties, and in certain events (such as death of a shareholder)) are contained in a separate shareholder or by-law agreement. In LLCs, the operating agreement contains both, which doubles the tonnage amount of an LLC document.
3. Contractual Basis/Freedom of Contract: Unlike a corporation where the code implies certain duties that cannot be waived by agreements, LLC members or owners are free to contract, particularly in Delaware. Operating agreements serve as the contract. Because everything must be spelled out, every case that comes out concerning the interpretation of an operating agreement requires drafters to insert more verbiage.
4. Nomenclature: Shareholders are members; directors are managers; shares are units. There are allocations of income, but distributions of cash, not dividends. It is confusing to people who are not familiar with the document.
And that, in a nutshell, is why LLC operating agreements are difficult to decipher.
Goodrich Law Firm, LLC
1 Inevitably, you always support the circumstances that whichever parent you are talking to is in or is about to be in, but that is just an aside.
2 http://alisondb.legislature.state.al.us/acas/codeofalabama/1975/coatoc.htm (Section 10A, Chapter 2)
3 http://alisondb.legislature.state.al.us/acas/codeofalabama/1975/coatoc.htm (Section 10A, Chapter 5)