By Michael Brier
Limited liability companies have become an increasingly common form of business organization, primarily because of ease of management.
They are also easy to form: most states do not even require a written operating agreement. Many entrepreneurs may find that they are just too busy to hash out an operating agreement – or are tempted to skip it to avoid the cost. Of course, foregoing an operating agreement works just fine as long as all of the LLC’s members are on the same page about how to manage the business. But as soon as the members disagree – which is likely to happen sooner or later – they are going to need to rely on default legal rules that often leave ample room for partnership disputes.
As a business litigator, I’ve seen my fair share of these types of cases. Here are some examples of disputes that can arise when Massachusetts’ default rules govern how an LLC is run.
Unclear Ownership
LLC membership interests are usually memorialized in the company’s operating agreement. When there is no operating agreement, the profits and losses of the LLC are allocated according to the unreturned capital contributions of the members. However figuring out how much capital a member has contributed to the LLC isn’t necessarily a simple task. This is because capital contributions can take the form either of money or property or services – sometimes known as “sweat equity.” So without an operating agreement, entitlement to distributions can depend on the highly subjective calculation of the value of a member’s contributions to the business.
Unproductive Partners
LLCs can have both service members – who directly work for the company – and passive investors who don’t. With an operating agreement, it is a fairly simple task to grant the service members extra compensation for their work for the company. But without one, the default rule applies: members of the LLC are entitled to profit distributions based on their unreturned capital contributions, and nothing else. This can become a significant problem if a service member stops pulling his or her weight or, even worse, stops working altogether: the entitlement to distributions never changes.
Management Disputes
By default, the management of the LLC is vested in its members, and a member’s voting power is determined based on his or her unreturned capital contribution. So the lack of an operating agreement can make it difficult to determine whether there is a majority in favor of a proposition that is up for a vote, or not. There is also no means of resolving a voting deadlock.
Furthermore, under the default Massachusetts rule every member has the power to bind the company. So you had better trust your business partners, because they can enter into contracts whether you approve of them or not (at least unless there is a majority decision of the members mandating an alternative course of action).
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Questionable Valuations
A partner who wants to resign from an LLC is entitled to do so for any reason on six months’ notice, at which point the partner is entitled to receive the fair value of his or her LLC interest, based on his or her right to receive distributions. This liability can obviously cause huge disruption for a company that doesn’t have the cash to buy out a member’s interest. Furthermore, there are different ways to value a business, like book value, discounted cash flow, or liquidation value, some of which may favor a buyer and some of which may favor a seller in certain situations. An operating agreement can head off disputes by selecting a methodology in advance and creating a way of resolving disputes without going to court.
Conclusion
A good operating agreement can’t eliminate the risk of litigation. But it can head off potential disputes, like the ones I describe above. A fairly small investment on the front end can help entrepreneurs protect what is in many cases their most valuable asset – their business.
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