Why does a small business need an operating agreement – part 2

Breaking up is hard to do … or at least, it should be!

In part 1​ we outlined what an operating agreement is. Go back for a refresher if you’d like … we’ll wait.
Now, one of the features of a good operating agreement is how it controls ownership of the members. You will recall that:
  • Operating Agreements and Bylaws are the rules by which a businessentity operates and almost all default statutory provisions can be updated by the agreements 
  • Provisions in the documents usually describe how members join and how interest is transferred. If no specific provision, state law applies, but the agreements can override state law. 

Forced Transfers

Interestingly, and importantly for a small business owner, provisions in the document can limit or force transfer in several ways. For example, an operating agreement might actually force a sale of the membership share under specific circumstances.

How about an example? Suppose one of your fellow members was in the middle of a messy divorce. If the soon-to-be-Exes agreed, it is possible that the divorcing member might give her shares to her husband in the settlement agreement. Then, through no plan of yours, you might have a new member who does not share your views about the business, and might even be a bit annoyed at your other owners and staff. How would that work in your business?
Can you do something to prevent this? Glad you asked … yes, we can! Here is an example provision that could force a sale in the event of a divorce:
Each Member agrees that if the Member suffers any involuntary transfer or purported involuntary transfer of part or all of the Member’s Shares, including but not limited to any transfer or purported transfer resulting from bankruptcy, insolvency, divorce, or otherwise, the Member shall be deemed to have made on the date of the event an offer to sell all of the Member’s Shares
In most cases, the Operating agreement should also provide that other members or that the company can (or, must) buy the shares. The key is not to let control of one member’s shares get outside the business too far … unless you want it to, of course!

Economic interest

Now, we should note that “membership interest” is usually thought of as “ownership” and often means that member’s shares also participate in the profit (or loss). It is possible in the operating agreement to separate ownership from economics. In that case, a divorce settlement might give an Ex-spouse the right to receive the distributions from the business each quarter. That doesn’t mean the Ex has a membership (e.g., “Voting” and management right) interest… only that he receives a profit check. You should be sure the operating agreement describes this case too.
Here is an example clause that uses a concept of “capital” shares to prevent a transfer of ownership interest:
Subject to the provisions of this Article, a Member may assign the Member’s Capital Shares in the Company in whole or in part. The assignment of Capital Shares does not itself entitle the assignee to participate in the management and affairs of the Company or to become a Member. The assignee is only entitled to receive, to the extent assigned, the distributions to which the assigning Member would otherwise be entitled.

Buy-Sell provisions

Another way operating agreements can limit transfers is through the use of buy-sell agreements. Buy-Sell agreements, or “Business continuation agreements,” require that the business interest is sold according to a predetermined formula to the company or the remaining members of the business.
A buy–sell agreement consists of several legally binding clauses in the operating agreement or a separate, freestanding agreement, and controls the following common business decisions (or others, depending on your needs):
  • Who can buy a departing partner’s or shareholder’s share of the business (this may include outsiders or be limited to other partners/shareholders); 
  • What events will trigger a buyout (the most common events that trigger a buyout are: death, disability, retirement, or an owner leaving the company) and; 
  • What price will be paid for a partner’s or shareholder’s interest in the partnership. 
  • The agreement or stock itself my impose Stock sale restrictions, Stock income restrictions 
  • Often, will include Non-compete clauses
The buy-sell agreement is very useful in valuations (we’ll cover that in Part 3 of this series) because there is an intrinsic formula to determine the value.

Funding a Purchase

Whether you have a buy-sell agreement, or a simple clause in your operating agreement, there is now a chance that your company might have to actually buy shares of a departing member. How can you afford that? Careful funding of Buy-Sell agreements is needed … and it looks very much like an insurance policy. First you define the triggering events. Death, Disability, and Retirement are common. Divorce and Bankruptcy less common – and insurance for those may be expensive.
Then, you define how to fund. There are several different methods. For example, Cross-Purchase Agreements create in each owner a personal liability, so all owners insure each other. While good for a small number of partners or members, this can be too complex for more than “several” owners and may impose tax implications on owners. In addition, insurance Expenses might be unfairly high for younger owners.
Another approach is an Equity Redemption Agreement. Here, the Business is obligated to purchase a departing member’s shares and so, the Business buys insurance on each partner/owner/shareholder. It is a more even distribution of expenses, but proceeds may be subject to business creditors, the disbursement may impose AMT on Corporation, and a majority owner with LPOA (limited power of appointment) might have estate implications.
A third, less common method is through use of an ESOP (Employee Stock Ownership Plan). Very generally, in this approach, a member sells shares to the company, which offers those shares to the employees under the ESOP.  This can generate cash, which is then repaid by the member. It can be an effective way to fund a buyout, but it is complicated.
Funding a buy-sell is not a one-stop answer … there are many possible solutions and you need to work with an attorney and a financial planner who can understand the unique issues you and your members face and who can find the most cost effective solution.

Terms of Sale

However you have designed the agreement, and however you value your business, your operating agreement also needs to describe the terms of sale.  Here is a sample clause that we have used:
The Purchase Price shall be paid in full by a certified or bank cashier’s check at the Closing; or, at the sole election of the Company, the Purchase Price shall be paid by the delivery of a certified or bank cashier’s check in an amount equal to 20 percent of the Purchase Price, and the balance shall be paid pursuant to a nonnegotiable promissory note of the Company (the Note) providing for equal annual payments of principal, together with accrued interest, over the following five years beginning on the first anniversary of the Closing.
Whew! Operating agreements can be a very important part of your business … when forming, and when splitting up. Be sure your does what you want.
Next, we will look at business valuations.  In the meantime, if you can’t wait for the next parts, give us a call. We will be glad to talk to you about your business, and your concerns about your operating agreement (or anything else that you need to talk over with us).
  • Part 3 – What is my business worth?
  • Part 4 – What do I actually own of my business?  Is it even mine?
  • Part 5 – Who’s next?
  • Part 6 – Protecting your business with an Operating Agreement.​

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