Perhaps the most popular form of business organization being used today is the limited liability company or LLC. One of the advantages of an LLC is its flexibility. The person or persons organizing under an LLC format have the ability to fashion their own specific management design or structure for their business. The way this is typically done is through an operating agreement. The operating agreement spells out how the business is to be operated and managed.
It is this very flexibility of an LLC that presents particular challenges at the formation stage. While there are many basic form operating agreements that are commonly used in setting up LLCs – some simply downloaded off the internet and others provided at “reasonable cost” by some attorneys – there is great potential danger to the adoption of any operating agreement without a careful and deliberative process. That generally requires competent legal counsel and involves a financial cost. While it is generally true that most start-ups are short on cash and have little interest in spending tight funds on attorneys, this is a classic example of being penny wise and pound foolish.
A typical example of this foolishness is a case we recently handled involving an LLC owned by two brothers. The brothers had an attorney prepare an operating agreement, but the brothers didn’t want to spend much money on setting up the business and so there wasn’t much discussion of how they actually intended to operate the business. The operating agreement provided was a low-cost, generic off-the-shelf form commonly used, but completely inappropriate to the realities of how the brothers would operate the business. Although each brother owned 50% of the business, the operating agreement requires that all business – every sale made– have the consent of the majority of the ownership interests and that in order to obtain that consent there would need to be a formal meeting. Like most other small businesses, the brothers simply put the operating agreement in a file and went on conducting their business in the way that made sense – even though that was contrary to the operating agreement. Years later, when the brothers had a falling out and litigation ensued, one brother found that the operating agreement suited his position which resulted in even more costly litigation. What may have cost a few hundred more dollars at the outset ended up costing tens of thousands of dollars to litigate.
In the classic Three Stooges episode A Plumbing We Will Go what starts out as a minor plumbing problem is turned into a massive plumbing disaster by three non-qualified guys just trying to help. You don’t have to be one of the Stooges to think that you can fix that leaky pipe only to find yourself hours later with a much bigger and more expensive problem for the plumber to fix. Avoiding the cost and taking the time to work with a competent attorney to draft an operating agreement that is appropriate to the realities of how you intend to operate and manage your business is comparable to hiring the Stooges to fix that leaky pipe in your house.
John B. Simpson, the author of this article and a trial attorney with MartinWren, P.C., has litigated a number of LLC cases that could have been avoided had the parties had a properly drafted operating agreement. For more information, please contact John at 434-817-3100.