Hammering out an Operating Agreement (OA)

Hello everyone,

So we have all heard the horror stories about how two (or more) investors got together, did a deal, and then fought for the next year about how the profits or losses should be split. Well, this situation is easily prevented with an operating agreement.

It is important to take note that even if you are on title with someone you should still get an operating agreement in place before any money is sent anywhere, even if it is your grandmother. If you are not sharing title with someone then there should be a second agreement in place known as a purchase agreement, but I will cover that in a separate article.

Here are some of the things that you need to look at in your operating agreement and make certain that they are written in your favor:

• Salary – you want to have your terms for the job. Yes, even though you are the operator and running the show it is still necessary to negotiate your management fee on the back end. Also, depending on the job’s timeline, it may apply to negotiate a fixed fee for the work.
• Distribution of assets – most likely you will have some clause in your OA about the distribution of the asset proceeds at the sale. This will most likely be in this order:

§First, to the payment and discharge of all of the Company’s debts and liabilities except those owing to Members or to the establishment of any reasonable reserves for contingent or unliquidated debts and liabilities;

§Second, to the payment of any accrued interest owing on any debts and liabilities owing to Members in proportion to the amount due and owing to each Member;

§Third, to the payment of outstanding principal amounts owing on any debts and liabilities owing to Members in proportion to the amount due and owing to each Member; and

§Fourth, to the Members in accordance with the positive balance of each Member’s Capital Account as determined after taking into account all Capital Account adjustments for the Company’s taxable year during which the liquidation occurs, including any Capital Account Adjustments associated with the allocation of Profits and Losses with respect to any Liquidating Transaction. Any such distributions to the Members in respect of their Capital Accounts shall be made within the time requirements of Section 1.704-1(b)(3)(ii)(b)(2) of the Regulations. If for any reason the amount distributable pursuant to this Section 12.3(d) shall be more than or less than the sum of all the positive balances of the Members’ Capital Accounts, the proceeds distributable pursuant to this Section 12.3(d) shall be distributed among the Members in accordance with the ratio by which the positive Capital Account balance of each Member bears to the sum of all positive Capital Account balances.

• Access to company records – A Member has no access, inspection, or copying rights with respect to Company records. However, a holder of twenty or more Percentage Interests may request of the Manager, access to the Company’s records, which access shall not be unreasonably withheld. Such inspection and copying, if any shall be at the Member’s expense.
• Voting rights – This is something that you want to avoid in an operating agreement. Usually, in an operator/investor relationship it is important to have full control for an operator. Imagine having a group of 3-4 investors who want to vote on every major decision for the duration of a year-long project.

Those are the major four points that you want to cover. There are other points that I did not mention because they are usually in a standard operating agreement. Some other points are: Tax matters, restriction of transferability, limitation of liability, LLC/operator information, and other various amendments and miscellaneous provisions.

Lastly, it is important to note to anyone who is interested in syndicating a deal or even just doing a joint venture partnership, always know that these provisions and others are negotiable. Usually there are a few back and forth negotiations to smooth out terms that are acceptable for both sides. The key point is to be honest and open to change, but make sure that it will not adversely affect the project, the investor, or yourself. Stick to your guns where you need to, but find a happy balance in other areas.

If anyone has any questions or wants clarification please feel free to comment or message me. 

Happy Holidays,

Dmitriy Chebotarev

If you are looking to get an operating agreement created then you should consult a real estate attorney.  I am not a lawyer and any content in this or any post should be taken as non-advocate advice.  Be smart about it.