I was teach a workshop in Dallas this past week when a prospective client asked me a question that resulted in the following conversation:
Q: “Why should I use Anderson versus a local attorney for my asset protection structuring?”
(Great question and one that a person who likes to do their homework should ask before deciding to enter into business relationship with an attorney in another state.)
A: “Not to be glib, but we are the best at what we do. We specialize in asset protection for real estate investors.”
Q: “Yes, but other attorneys have told me they work with real estate investors so what makes you different?”
A: “We just don’t work with investors – we are investors. We understand the complexities or real estate investing better than most because we are in the trenches working on our own deals and yes, some have worked out. We apply what I will refer to as “dirt smarts” in our client planning. My role as your advisor is to foresee the potential problems then look for solutions to minimize these issues down the road. Think of it in terms of taking a daily aspirin to prevent headaches. There are no guarantees that you will never get a headache but the aspirin regimen may decrease and probably lessen the severity of any future headaches.”
Q: “Can you give me an example?”
A short time ago one of my clients decided to partner with three other individuals in an apartment building. The deal was straightforward. Each partner would contribute a set amount of money for their membership interest in a newly formed LLC. My client would receive a sixteen percent interest for his contribution. The majority partner in the transaction held fifty percent and would serve as the LLC’s Manager. The majority Member had his attorney, reputed to work at “a respectable firm” and is familiar with LLCs for real estate transactions, draft the operating agreement. Shortly thereafter, an operating agreement was emailed to each of the Members for review and signatures. (You can view a copy of the operating agreement here.)
If you haven’t looked at the agreement, I suggest you do then ask yourself would you sign it? If not, why? Read on and I will give you several reasons why this agreement will end in disaster for any parties brave enough to sign it.
Problem: The operating agreement does not define the term “Majority” when referencing decisions reserved to the members.
Issue: What constitutes a “Majority”? Does this refer to the number of members or a certain percent of ownership?
Solution: Define “Majority” in the agreement to equal at least a percent of the membership interests or a number of members. In my opinion this agreement should define “Majority” as 75% of the membership interest or more than 2 members (assuming the LLC will not admit additional members) so decisions require the approval of at least 3 members
Problem: The Manager can request the Members to contribute additional cash to the Company.
Issue: This unfettered power could allow the Manager to freeze any Member out of the LLC by making a request for additional capital. If a Member does not have the ability to make the capital contribution his ownership will be forcibly reduced.
Solution: Sensitive to the need for capital calls if unexpected expenses arise and the LLC does not have sufficient cash reserves, this decision should be made by the collective membership and not solely by the Manager.
Problem: Any Member may transact business with the Company without restriction.
Issue: The Manager could set up separate business ventures to provide services to the Company thereby enriching himself at the expense of the other Members..
Solution: Restrict related parties from dealing with the Company unless a majority of the Members approve.
Problem: The Manager/Management Committee is determined by the Members from time to time.
Issue: The operating agreement does address how to elect or remove a Manager from the Management Committee. It would appear that the initial Manager is appointed for life.
Solution: Include a provision to elect or remove a Manager. The provision should address who is entitled to vote, i.e., the Manager being removed should not be permitted to vote.
Problem: The Manager is given exclusive control over the Company.
Issue: The Manager could sell or encumber the Company assets without the approval of the Members.
Solution: The sale of Company assets above $8,000, the encumbrance of assets, or excessive expenditures above $10,000, should be reserved to a vote of the Members.
Problem: The Manager/Management Committee is required to have at lest one annual meeting but there is no mention of Members being invited.
Issue: The Manager can run the company without reporting to the Members.
Solution: The Manager must report to the Members at least quarterly and Members should be given the option to attend any meetings.
Problem: The Manager can hire any person as the Manager determines necessary for running the Company.
Issue: The Manager could hire friends and family to work for the LLC and drain resources.
Solution: The operating agreement should restrict or limit any transaction with a related party unless approved by a majority of the Members.
These are just a few of the problems I pointed out to my client regarding this joint venture operating agreement. The main reason to adopt an operating agreement is to make sure that you and your co-members have established procedures for how the business is to be run. With a poorly drafted operating agreement, or in many situations the lack thereof, the Members will ultimately be unable to settle their misunderstandings resulting in violated expectations and company failure.