When helping clients set up a new LLC, one of the primary documents that we discuss is the operating agreement. The operating agreement is a foundational document for any business, outlining its structure, ownership, and operational guidelines.
If you are using an online document preparation service, they will often give you a basic form with your information mail-merged in. Sometimes, the document is not even for the state where your business is formed. But for the small price you pay, they aren't able to give you the personalized attention to make sure your agreement has all the provisions you actually need.
Many clients who form their business themselves also put off creating their Operating Agreement entirely. It's not a high priority and unless you are in a state that requires that you sign one, those business owners assume they are just fine without an agreement.
One crucial aspect that is missing in your business without an operating agreement is how to handle the buyback of an owner’s interest, especially in the event of significant life changes like divorce. Including specific provisions in your operating agreement can safeguard the business and its remaining owners from potential disruptions.
The Importance of Buyback Provisions
Including a buyback provision in your operating agreement allows the business to repurchase an owner's interest under certain conditions. This mechanism is vital for maintaining stability and continuity within the company. Several triggering events can activate a buyback clause, with the divorce of an owner being a common and critical scenario.
Why Divorce is a Significant Trigger
Divorce can have a profound impact on business operations, especially in companies with multiple owners. During divorce proceedings, an owner’s interest in the business can become entangled in the division of marital assets, potentially leading to an ex-spouse becoming an unintended business partner. To mitigate this risk, your operating agreement should clearly define the procedures and conditions for buying back the divorced owner’s interest.
Structuring Buyback Provisions
When drafting buyback provisions, consider the following key elements to ensure they are comprehensive and enforceable:
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Triggering Events: Clearly outline the events that will trigger a buyback. Besides divorce, other events may include death, disability, bankruptcy, or voluntary departure of an owner. By specifying these triggers, you provide a roadmap for handling such occurrences.
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Valuation Method: Establish a method for valuing the owner's interest. Common approaches include fair market value, book value, or a predetermined formula. Agreeing on a valuation method in advance prevents disputes and ensures a smooth transition.
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Payment Terms: Define how the buyback will be financed. Options include lump-sum payments, installment plans, or using life insurance proceeds in the event of an owner's death. Clear payment terms help manage the financial impact on the business.
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Approval Process: Specify the approval process for buybacks. This might involve a vote by the remaining owners or a decision by the board of directors. An established process ensures transparency and fairness.
Restricting Ownership
In addition to buyback provisions, placing restrictions on ownership can further protect the business. These restrictions help maintain control over who can become an owner, ensuring that all stakeholders align with the company’s goals and values. Some examples of ownership restrictions that I've encountered:
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Specified Group Ownership: Limit ownership to a defined group of individuals, such as current employees, family members, or existing owners. This restriction prevents outsiders from gaining control or influence over the business.
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Non-Voting Interest Conversion: Automatically convert an owner's interest into a non-voting interest upon certain events, like divorce. This approach allows the ex-spouse to receive financial benefits without impacting business decisions.
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Transfer Approval: Require prior written consent from other owners before transferring ownership to third parties. This restriction ensures that all new owners are vetted and approved by the current ownership group.
Addressing Ex-Spouses
To specifically address the impact of divorce, consider including a prohibition against an ex-spouse receiving any ownership interest. In such cases, if a court awards an interest to the ex-spouse, it would only be as an assignee, not an owner. This means the ex-spouse can receive financial benefits but does not gain voting rights or control over the business.
Practical Considerations
When incorporating these provisions and restrictions into your operating agreement, consult with legal and financial advisors to ensure they are legally sound and tailored to your business's unique needs. Here are a few practical tips to keep in mind:
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Regular Reviews: Periodically review and update your operating agreement to reflect changes in the business environment, ownership structure, or legal requirements. Regular updates ensure the agreement remains relevant and effective.
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Clear Language: Use clear and unambiguous language to avoid misunderstandings and disputes. Legal jargon should be minimized, and key terms should be clearly defined.
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Documentation: Keep detailed records of all ownership changes, buyback transactions, and approvals. Proper documentation provides a clear trail of decisions and actions, supporting transparency and accountability.
A well-crafted operating agreement is essential for protecting your business from unforeseen events like divorce. By including robust buyback provisions and ownership restrictions, you can ensure the continuity and stability of your company. Taking proactive steps to address these issues helps maintain control, align ownership interests, and safeguard the business’s future.
Remember, each business is unique, and there is no one-size-fits-all approach to drafting an operating agreement. Collaborate with your advisors to tailor the agreement to your specific needs and circumstances, ensuring it provides the protection and flexibility your business requires.
Do I Need a Business Attorney?
Now is a good time to get up to date on your LLC documents, so if you'd like to discuss them further, let's schedule a Legal Strategy Session online or by calling my Edina, Minnesota office at (612) 294-6982 or my New York City office at (646) 847-3560. My office will be happy to find a convenient time for us to have a phone call to review the best options and next steps for you and your business.
