As if there aren’t enough provisions in an Operating Agreement (or Owner’s Agreement) already, there are two key provisions that go hand-in-hand, and we’re here to shed some light on them! To put things into perspective, an Operating Agreement is a document that governs the internal operations of your limited liability company, and although not required in every state, it’s still imperative to have one. One of the primary reasons we recommend every client have an Operating Agreement executed for their LLC is to prevent the application of default state rules in the absence of the Agreement. Remember: the default state rules are adopted to be beneficial to the average business—that doesn’t necessarily mean your business. (If you haven’t done so already, check out our recent blog on Operating Agreements for more information on their functionality!)
Buy-Sell Provisions
All multi-member Operating Agreements should contain a “buy-sell” provision that governs in the event a member of the LLC dies or otherwise leaves the business. The purpose of the provision is to stipulate a framework for exactly how a member’s ownership share may be transferred, because once they leave the LLC—what happens to those shares? These provisions typically outline the triggering events in which a member may transfer their ownership share, exactly who may purchase that share (whether it be a third party or existing members of the LLC), and the process for resolving disputes amongst the members. If you’re like most entrepreneurs, your business is a prized possession and you should want to have a say in exactly how ownership interests are transferred. For example, maybe you have an established family-owned business and you’d like to keep it that way—how can you ensure that happens after your own death? Having a buy-sell provision can stipulate that only the LLC, or any member(s) of the LLC, can purchase your share and not an outsider who may not possess the same vision for the business. Another example: maybe there’s a disagreement amongst the remaining members in how the departing member’s ownership share be transferred, which results in a lengthy (and costly) dispute. A deadlock over a buy-out can cause tension within the business itself, thus outlining the process for deadlock avoidance will alleviate a lot of headaches down the road.
Valuation Provisions
While the buy-sell provision provides the framework for transferring a departing member’s ownership interest, the valuation provision provides the methodology for exactly how the purchase price is to be calculated. There are several methods that may be employed in valuing the LLC, but the most common are typically through an appraisal method. Some valuation provisions will provide for a previously and mutually agreed upon appraiser to complete the valuation, while others opt for separate appraisers, hired by the respective parties to the transaction, from which an average is then determined. In some less common scenarios, members may agree on a listed value in the Operating Agreement or a specialized formula may be created. Regardless of the method of valuation, having a valuation provision in your Operating Agreement allows you to choose which method is used.
If you’ve read this far and have realized that you don’t have buy-sell or valuation provisions in your Operating Agreement, or you don’t have an Operating Agreement in general—don’t worry, there may still be time for you to execute an Operating Agreement for your business or amend your current agreement to include these vital provisions. Businesses formed in the state of Connecticut or Massachusetts can contact Marti Law Group for a free 30-minute consultation at: info@martilawgroup.com or 860-552-7770.