After you sign your player's contract and get that first check, investment opportunities will start making their way towards you. At some point, you’ll eventually encounter an operating agreement for a business organized as a limited liability company (LLC).
An operating agreement (also known as a limited liability company agreement) is the governing document for an LLC and, among other things, lays out the rights and obligations of the LLC members, how the LLC will be operated, membership interests and profits, loss and distribution allocations. In certain situations where the operating agreement is silent on matters, the state where that LLC is organized will have laws to govern those matters.
When you receive an operating agreement, the first thing you’ll notice is its length and denseness. Although the temptation will be high to rely only on what a future LLC member tells you about the operating agreement, please try to refrain from doing just that. Instead, you’ll want to make some time to go through it to see exactly what the deal is offering you and what you're offering.
Ideally, you’ll make some time to share your operating agreement with a trusted legal advisor to get helpful comments and suggestions (especially if you’re putting in a significant amount of money), but if you’re intent on handling an operating agreement alone, this blog post shares 14 important questions to ask before signing an operating agreement.
Obligatory Note: This blog post is meant to provide you with an overview of some of the important terms within an operating agreement. As such, the questions below are just some (not all) of the questions you’ll want to ask and have answered. Every transaction will be different, with each one presenting a whole new set of questions. This blog post is not, and should not be construed as, a substitute for discussing your specific situation and operating agreement with a legal advisor. For more limitations on the use of this blog post, please see see our legal disclaimer.
1. Is the LLC subject to the operating agreement in good standing?
All states have a state agency (for many, it’s their Secretary of State office) that handles legal entity formations and other filings. These agencies offer consumers the ability to search their agency databases for detailed information about corporations, LLCs, partnerships and more.
Example: Check out Washington Secretary of State Office’s corporation page here. Once there, type in “Amazon.com, Inc.” in the search field. In the list of names returned, find the name that matches your search entry and click on it. You’ll see some basic information, such as where the corporation was formed and how you can purchase additional documentation on Amazon.com, Inc.
Additional documentation includes a Certificate of Authorization (sometimes called Certificate of Good Standing), which is official proof by a state that the legal entity in question is legally permitted to transact business within a state. Each year, these certificates are updated when a legal entity completes an annual report with the appropriate state(s). Failure to complete this annual report could result in the loss of authorization to transact within the state, dissolution of the legal entity or any number of other restrictions imposed by the state. All of these consequences could hinder the business from legally operating within the state, which could result in lawsuits from third parties, loss of financing from banks, inability to sue other parties and more.
Before you contribute capital to an LLC, you’ll want to find out if it has good standing in the state where it was formed and/or where it is authorized to transact. (You can check this by following the steps in the example above.) In most LLC operating agreements, you can find the LLC information in the first paragraph of your operating agreement. The language will look similar to this:
This Operating Agreement (this “Agreement”) of John Doe Worldwide, LLC, a Washington limited liability company (the “Company”) is made and entered into as of June 16, 2016.
Using this example, you would visit the Washington Secretary of State Office’s website and search the LLC database for John Doe Worldwide, LLC.
Once you find the LLC, you can then purchase a certificate of good standing (sometimes these are free) to obtain its official status with the state. Here's an example of a Certificate of Good Standing for for Molson Coors Brewing Company:
If you find out the LLC is not in good standing, follow up with the other future LLC members and get some answers before you invest. (Note: In some instances, you may receive an operating agreement before the LLC's articles of organization are filed with the secretary of state. If this is the case, there may not be a record with the secretary of state at all.)
2. Who is managing the LLC?
The manager of the LLC plays an important part in making sure your investment meets its objectives and gives you the return you expect to receive for your investment. For LLCs, the manager can be either an LLC member (member-managed LLC) or a third party manager (a manager-managed LLC), such as a hired investment manager. Furthermore, the manager can be a person or another legal entity, such as an LLC or corporation.
The manager’s responsibilities and duties will vary according to the nature of the business, but they can include hiring and firing employees, entering into financing arrangements on behalf of the LLC, choosing the LLC's investment, purchasing equipment, entering into other agreements, diluting your membership interests without your approval (yes, watch out for this one) and more.
If you are not the manager or part of the LLC's management committee that oversees the LLC’s operations, you’ll want to get more information on the manager (such as its history managing other businesses) and any prior or existing management obligations it has, or has had, somewhere else. You’ll want this information to find out if the manager will (i) be fully dedicated to your business while your investment funds are being used or (ii) have the leeway to not only manage competing businesses but dedicate more time to those other businesses. It would also be good to know if your manager or any of its previous businesses, if any, have filed for bankruptcy or been a defendant in any lawsuits, civil and criminal.
Lastly, if you haven’t met the manager yet, you’ll want to set up time to sit down and talk to them about the planned business, family and other topics to gauge if he or she is someone you want working on your behalf. If you get a vibe you can’t trust the person after several meetings, you may want to reconsider agreeing to the management structure and/or investing in the business.
3. Is there a management agreement?
Depending on the LLC and its operating requirements, there may be a management agreement that allows the manager to receive a periodic payment for its management services. This payment is typically called a management fee.
Sometimes, the management fee is warranted, especially for manager-managed LLCs. No matter who is managing, if there is a management fee being paid to someone other than you, make sure the fee is commensurate with the type of services being provided to the LLC.
Example: If the manager is actively managing employees, making sales calls, managing an inventory and a supply chain, etc., $2,000 per month might be reasonable. If the manager is just printing checks on a single day of the month to pay suppliers, $2,000 per month might be unreasonable.
When trying to determine what’s reasonable, simply look to your local job market. What is the going rate for similar services provided by someone off the job market in your community? Take that amount and compare it to the management fee. Is it reasonable?
So the key here is to find out how much the manager gets paid, the frequency of that payment and when those payments are supposed to be made.
4. What rights do you have to remove the manager?
In a situation where you're determined to be a part of a business idea, and the other party isn’t budging on (i) being the manager, (ii) the management fee and (iii) the extent of the manager’s services, you may be able to still retain some control over your investment by having the right to remove the manager. Be aware, however, that the manager removal right is a hotly negotiated term.
Ideally, you want to be able to remove the manager at your own discretion, but the other party won’t give you that much power, especially if the manager is getting a fee. So if there is room to negotiate, you’ll want to be able to remove the manager when the required management services are being poorly provided and/or not meeting the standard of care provided for under the operating agreement.
If you're not careful with the contract language for measuring the manager's performance, however, you can end up with a performance threshold that is subjective. An example of a basic subjective threshold is "manager may be removed for providing poor management services." How do you define "poor management services"?
Instead, you'll want to include objective goals, such as a specific sales revenue total or number of products sold. This way, whether a manager is meeting the desired performance requirements will be easily observable from an outside party and/or a court, if needed.
5. What is the manager’s standard of care?
Standard of care refers to how well the person with a duty to perform an activity should perform that activity. In view of an operating agreement, the standard of care will help set a baseline for measuring whether the manager has been negligent in carrying out duties and, therefore, subject to claims for damages or removal or both.
Example: you may see in your operating agreement that a manager’s fiduciary duty to the LLC is to carry out actions “in good faith.” Due to the subjective nature of “in good faith,” courts in different jurisdictions have different meanings on what “in good faith” even means. The inability to define “in good faith” gives the manager wiggle room in carrying out its duties. This means the manager could be acting unreasonably but because it thought it was acting reasonably, it could still meet the “in good faith” standard of care. In terms of drafting contracting language, "in good faith" will be too loose for your purposes, if you're not the manager.
Let’s compare “in good faith” to “reasonable efforts,” or the reasonable person. A manager who has a standard of care pegged to what a reasonable person would do is much more capable of being held accountable for actions that hurt your investment. So instead of the court looking to the mental state of the manager and circumstances under which it acted, like it would do with an “in good faith” standard of care, the court will compare the manager to the actions of a reasonable person under the similar circumstances of the manager, holding the manager to a higher standard of care.
At the end of the day, if you decide to negotiate the standard of care in which the manager is to discharge its duties, you’ll want, at a minimum, the reasonable person standard of care to apply.
6. What are your voting rights?
The operating agreement may provide that certain actions require a higher percentage of votes than others. For example, admission of a new member may only require a supermajority (commonly greater than 66% of the votes), whereas entry into a new lease agreement may require only a majority (greater than 50%). Larger actions, such as a reorganization or a merger, might require unanimity (100% of votes are in agreement) from all members.
Even with these varying levels of consent, none of them will matter if you are not given voting rights at all with your membership interest, which is something parties can agree upon. So be sure to check to see if the voting rights to your membership interest are restricted in any way. To find out if there are restrictions on your level of involvement in the LLCs operations, look for a section entitled “Membership Voting,” or something along those lines. It’s a good starting place to find out your voting rights. From there, you’ll have to look through your operating agreement for the activities that require voting, and those sections could be in various sections in your operating agreement.
7. How will profits, losses and distributions be allocated?
In regard to allocations, the default approach is to allocate profits, losses and distributions according to your membership interest. Under a default approach, if you have a 45% membership interest, your allocations are equal to 45% of the profits, losses and distributions.
An operating agreement, along with state LLC laws, allow members to contract around this default approach, so an unsuspecting member could easily end up with unfavorable allocations.
Example: If you are the only member contributing capital to the LLC and receive a 45% membership interest but your allocation of net profits is only 35%, you’ll want to get a full understanding as to why that is your allocation percentage. You may find out that another member believes its contributions through sweat equity is more valuable and deserves a disproportionately higher allocation.
A simple allocation clause will look like this:
“Except as may be required by the Internal Revenue Code or the Treasury Regulations or this Operating Agreement, net profits, net losses, and other items of income, gain, loss, deduction and credit of the LLC shall be allocated among the Members ratably in proportion to each Member's LLC Unit Percentage. For example, if a Member has an LLC Unit Percentage of 45%, he or she shall be allocated 45% of all profits or losses (and other allocation items) for any given tax year.”
Distributions, both non-liquidating and liquidating, are staples in operating agreements. Similar to the allocation of profits and losses, distributions can be made according to membership interests. Thanks to the flexibility of LLCs, however, distributions can be structured in a variety of ways.
One common method to distribute cash and other assets is through a “waterfall” provision. Under a waterfall provision, a hierarchy is established, and distributions are made according to the hierarchy. Distributions under a waterfall provision can look something like this:
100% of proceeds are used return capital contributions to investors,
then the remaining proceeds are applied to an agreed upon return for the investors, and
whatever amount of the proceeds is remaining is to be split between the manager and members.
If you are the only one contributing capital, you may consider a "waterfall" provision to make sure you recoup as much of your investment as you can before it gets paid out to other members.
8. What does your membership interest offer you?
LLCs offer members flexibility with their capital structure, so your membership interest can be voting or non-voting, preferred, convertible and any number of other things. The easiest way to think about your membership interest is that it is made up of two parts:
an economic interest (how much will I get paid?)
a management interest (how much control do I have over the operations?)
Specifically, your membership interest tells you how much say you have when it comes to management decisions of the LLC and your allocation of profits, losses and distributions. So as you can see, your membership interest is an aspect of an operating agreement that needs to be understood thoroughly.
Since many states allow LLC members to contract however they want in regard to their membership interests and the benefits attributed to them, other future LLC members can easily create an a membership interest structure that is heavily in its favor, regardless of how much capital you contribute. So be especially careful when it comes to your membership interest.
(Note: If you decide to forgo legal advice on all other aspects of your operating agreement, I highly recommend you at least seek out professional input on your membership interest.)
9. What membership interest transfer restrictions are in place?
Under most operating agreements, your ability to transfer your membership interest in the LLC will be limited. Transfer may require approval of the manager or other members or both. Generally, restrictions are in place to:
reduce the chances of breaching a covenant under a loan agreement,
prohibit the company from become subject to dissolution under LLC laws,
prevent securities laws violations,
avoid unwanted tax issues or
eliminate or mitigate other unwanted consequences.
If you have plans to exit the company at a certain date and time, or desire to have more flexibility on when you can exit your investment position, you should bring up those specific concerns with the manager, other members and/or your legal advisor.
10. What rights are you waiving?
Today, most states, if not all, have an LLC act that regulates the organization, operation, distributions and dissolution of LLCs. These acts provide details around the operating agreement, specifying what cannot be modified by agreement. These operating agreement limitations vary by state, with some states permitting the elimination of a member’s or non-member manager’s fiduciary duty and duty of loyalty and care to the company. This is important because this elimination may permit the non-member manager or another member to act on its own behalf without fear of a lawsuit.
If you are the primary investor and have limited, or no, management powers, you’ll want to review your operating agreement for any waivers and releases of claims against a non-member manager or another member for its breach of fiduciary duty or duty of loyalty and care. Here’s an example of how that waiver and release may appear:
“The Members agree that the Manager may continue to maintain its ownership interest in and perform services for the Existing Entity and any Future Entities without any violation or breach of this Agreement, acknowledge that such activities may create potential conflicts of interest between or among the various businesses, and hereby waive and release any and all claims against the Manager and its directors, officers, and shareholders for breach of fiduciary duty or otherwise arising from any such activities.”
By waiving these claims, you’re effectively giving a non-member manager or another member the ability to look after its own financial interests without fear of breach of duties claims. This freedom, coupled with favorable allocation of profits and distributions, can significantly impact the return on your investment and/or drain your investment in its entirety.
Unless the respective state’s LLC act prohibits the elimination of duties through an operating agreement, these waivers and releases may be inserted into an operating agreement. This waiver may even be in your operating agreement. As a result, you’ll want to review your operating agreement to determine if you are waiving and releasing claims against a non-member manager or member, and if that’s something you don’t want to do, you’ll need to negotiate to have those terms removed.
11. Will you be indemnified for claims against you?
LLCs are designed to limit your personal exposure, but this design does not mean you still cannot be sued by another party. Even with a solid defense and "clean hands", you may have to front the costs for a legal defense team to prove you are not liable for any claims arising from the operation of the LLC asserted against you. Similarly, if you are found liable, you may have to pay.
To make sure you receive coverage for any attorney’s fees, penalties, judgments and fines and settlements that are incurred as a result of a claim against you that arises from the LLC’s operations, you’ll want to make sure there is an indemnification clause in the operating agreement that specifies when and how you will be indemnified for the costs relating to claims arising from the LLC.
12. Are conflicts of interest permitted?
As you progress in your athletic career, you’ll be presented with a variety of other investment opportunities along the way, some of which may conflict with responsibilities and duties you owe to the LLC.
Through your operating agreement, your ability to participate in those other opportunities may be limited by way of certain agreement terms that restrict your (i) participation in competing businesses or (ii) investment in business opportunities that could go to business in which you owe a duty of loyalty.
If you believe you might have a business that competes, or will compete, with the business underlying the operating agreement you’re planning to sign, you’ll need to determine if there is non-compete or right of first refusal language that’s applicable to you. Similarly, if you know you won’t have anything to compete with the business, and the non-member manager or another member will, you might consider including non-compete and non-solicitation language to restrict their behavior, if that type of language isn’t in the operating agreement already.
Conflicts of interest clauses are important to review and understand. As a potential investor in a business, you'll want to know the manager or another member will continually seek opportunities that improve your investment rather than improve a competing investment in which the manager or another member holds an interest. If the manager or another member is permitted to personally take advantage of opportunities that should go to your business, your return on investment and the investment itself, may be at risk.
At the same time, if you want to run a competing business, you'll want more favorable conflict of interest language that allows you to continue to participate in both businesses without claims of breach of duty of loyalty.
13. Will you be personally liable for any of the LLC’s debt or obligations?
Generally, the LLC will shield you from personal liability relating to the LLC’s debt and obligations to third parties, members and managers. Depending on your state’s LLC laws, however, you can agree to be personally responsible for any and all debts and obligations the LLC may incur (including any obligations that may arise from a lawsuit). Being personally liable means third parties, members and managers can choose to come after you in your individual capacity for any debts or obligations the LLC is unable to pay.
If you do not want to be on the hook for payments the LLC is unable to make, you’ll want to make sure there is no language within your operating agreement that will make you personally liable.
An example of language that could protect you from personal liability looks like this:
All debts, obligations and liabilities of the LLC, whether arising in contract, tort or otherwise, shall be solely the debts, obligations and liabilities of the LLC, and no member shall be obligated personally for any such debt, obligation or liability of the LLC solely by reason of being a member.
If you find that you will be personally liable for the LLC's unpaid debt and obligations, and that's something you don't want, you'll have to negotiate a revision with the other member(s) to expressly limit your personal liability.
14. Who is allowed to amend the operating agreement?
Once you’ve put in the effort to get operating agreement terms in your favor, making sure those terms can’t be unilaterally removed or amended by another member or non-member manager is critical.
Depending on your state, LLC laws may permit members to agree on allowing a single member the right to amend the operating agreement without putting the amendment up for vote. If you're not certain your state's LLC laws prohibit such an agreement, you'll want to check the amendment clause in your operating agreement for any language granting a party other than you the ability to amend the agreement without your consent.
Here's one example of contract language about amendments:
This Agreement may be amended by, and only by, a written resolution setting forth in detail the amendment and signed by sufficient Members to reflect a supermajority vote interest of LLC Members in favor of said amendment.
Compare the example above to the this example:
The Manager will have the power, without the consent of the Members, to amend this Agreement.
If you're not the manager, which contract language would you prefer?
Summary
There are a lot of points within an LLC operating agreement that could be contentious, and if you're uncomfortable with reviewing the operating agreement in its entirety while also researching applicable laws and negotiating with other parties to swing things in your favor, the best route is to sit down with a legal advisor to talk about how to get your deal done while also protecting your investment.
If you have a few questions of your own that you would like to just talk through, sign up for a free consultation here to learn more about the McCauley Report, a report prepared by me that I use for reviewing and documenting a variety of legal agreements for athletes.
Have some additional questions you ask when reviewing an operating agreement? Please share in the comment section provided below.
Chris McCauley, CPA, Esq. is the founder of McCauley Investment Risk & Legal Consulting PLLC, a Seattle-based law firm dedicated to helping professional athletes guard their earnings and investments. Chris is an attorney licensed to practice in Alabama and Washington and a CPA licensed to practice in Washington and North Carolina.