When two or more people go into business with each other, they usually do so with high hopes, a sense that they’re all in this together, and the best of intentions. But we all know that hopes sometimes get dashed, togetherness can easily fall apart, and the road to hell needs paving (better before one travels down it).
If the relationship between business partners deteriorates, how that relationship began plays an oversized role in how it will end and/or be resolved. Specifically, the type of entity chosen – typically a corporation (however taxed), partnership, or limited liability company (LLC) – can determine whether a business divorce proceeds in an orderly fashion or becomes an expensive and disruptive morass.
For several reasons, an LLC offers advantages to members and constituents at the end of any such relationship that mirror those it provides while the enterprise is humming along. While each state has its own LLC laws, they all have one thing in common: the ability to contractually create the entity’s governance structure.
In this regard, perhaps one of the most significant advantages of LLCs is the ability of members and constituents to define their respective rights and obligations, including what happens when they disagree or one party wants to part ways with their fellow member(s) otherwise. Subject to some limitations that may exist in state law (and no business owner is tied to any particular state to form an LLC), this vehicle for doing so can be set forth in a detailed and comprehensive LLC operating agreement.
Operating Agreement As A Pre-Nuptial Agreement
While state LLC laws may establish or limit certain rights and/or obligations of the entity and its members, managers, or other constituents to third parties and taxing authorities, an LLC operating agreement can be a controlling contract that sets forth the details of the relationships between the members, managers and other constituents relative to each other and the LLC itself.
Among other things, a well-crafted operating agreement can define such core issues as voting rights, business activities, management structure, and management authority. But a comprehensive operating agreement can also address circumstances that, while not desired or inevitable, are an inherent risk of any business relationship. In this sense, an operating agreement can accomplish many of the same things that a pre-nuptial agreement can when entering into a marriage – a structured way to resolve issues and end a relationship without a great deal of acrimony. By setting forth in detail what can and will happen when members want to part ways, transfer their interests, or simply operate the entity, an LLC operating agreement significantly reduces the chances of protracted litigation.
For example, an operating agreement can address what happens if the manager dies or becomes disabled or what happens if, in a two-member LLC, the members can no longer get along with each other but both still want to operate the business. It can ensure that there are sufficient funds to buy out the interest of a member under certain defined circumstances and also limit who can acquire that interest. It can set forth a specific valuation methodology so that the LLC can purchase the interest of a departing member with minimal disagreement as to the appropriate worth of that interest.In the event the LLC buys out a member, the agreement can also provide for how capital accounts of the remaining members should be adjusted to spread out the departing member’s interest.
Often, a dispute between LLC members involves more than disagreements and divergent interests. One member may believe that another is violating their fiduciary duties to the business or the other members or is otherwise engaging in malfeasance. Subject to any statutory limitations, an operating agreement provides a mechanism for clarifying the nature and scope of the duties, powers, and discretion of members, managers, and other constituents. This, in turn, can limit what conduct can lead to claims that a party is breaching its fiduciary or other obligations.
Fortifying The Corporate Veil
A well-crafted – and well-adhered to – LLC operating agreement can also strengthen the protection the entity provides members against creditors who may seek to “pierce the corporate veil” (i.e., “penetrate the entity”) and pursue personal assets before or after the dissolution of their LLC. While some states have a limited statutory framework for such claims, they can often be minimized in the context of an LLC with a strong operating agreement. While the issues relating to creditor protection for individuals in an LLC (compared to corporations, for example) are beyond this article’s scope, the fact remains that a significant advantage exists for LLC owners, managers, and constituents in being able to ensure a bullet-proof entity. Certainly, two-member LLCs are one aspect of LLC protection.
Many small business owners choose to form an LLC because of the perception that there are fewer corporate “formalities” than there are for corporations. While that is largely true, taking that informality too far can expose those LLC owners to the very personal liability for company obligations that led them to form the entity in the first place.
Evidence that an LLC and its members adhere to the provisions of a detailed LLC operating agreement can solidify the legal separation between the business and its individual members and thwart efforts to pierce the corporate veil.
For distributors interested in further follow up on this topic, or to discuss new operating agreements, concerns about an existing operating agreement or questions, please contact me at 312-840-7004 or fmendelsohn@burkelaw.com.
