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Protective Provisions in LLC Operating Agreements: Why They Matter
You came up with the right business idea, formally organized your LLC, are about to raise some seed money from friends and family, and you are ready to prepare the operating agreement for your company. Or maybe you are a prospective investor, and you believe in the idea and team behind a business operated as an LLC that pitched you for a capital investment. Whether you are a founder or investor, the protective provisions (sometimes referred to as "major decision" provisions) of an operating agreement are critical to consider, understand, and have appropriately drafted in the LLC operating agreement.
What Are Protective Provisions?
Generally, a designated manager (or board of managers, such as if there are multiple founders) is granted with the power and authority to decide, approve, and conduct the day-to-day decisions of an LLC. However, the "protective provisions" give rights to investors, whether through their representation as a manager on the board or through their voting rights as members in the LLC, to approve certain decisions of the company. These approval rights are often critically important to the long-term success of the company and its investors. The protective provisions are often heavily negotiated by investors and founders.
While the protective provisions for anyone operating agreement may be deal-specific, a list of typical ones that both founders and investors should evaluate includes:
An increase or decrease to the authorized amount of membership interests (or designation of differing classes of membership interests, particularly classes which are senior to or on parity with the class of interest held by investors);
The redemption of previously issued membership interests (other than under equity incentive plans or employment agreements giving the company a repurchase right on discontinuation of services);
The company's making of distributions (other than tax distributions);
The company's borrowing of money above a designated threshold amount;
The sale of the company or another other change of control transaction;
An increase or decrease in the number of the company's managers;
Changes to the annual budget above certain threshold amounts;
The hiring of executive employees (and/or compensation levels above a designated threshold amount); and
The amendment of certain fundamental provisions of the operating agreement (such as distributions, allocations, and other similar provisions that were likely a fundamental basis for a member's willingness to make an investment in the company).
Why Do Protective Provisions Matter?
It is self-evident why protective provisions matter to investors in an LLC. Without them, the founders have unfettered ability to spend company money, and to otherwise make unilateral decisions for the company or themselves, that may have no relation to the overall interests of the investors and/or the protection or increase of the value of their investment.
What is sometimes less obvious is the impact of protective provisions on the interests of founders and their ability to operate the company in the manner they may feel most prudent to all constituents involved. For example, it is probably not a wise idea to give extensive protective provision rights to investors for a relatively small overall investment amount. Consider an instance where the total investment is $50,000. In these cases, for an early-stage startup to need to obtain approval from investors on each major company decision can be impractical and overly time consuming, particularly where the investor is not involved day-to-day and is not truly in the same position as the founders to best assess the company's needs and objectives.
For more significant investments in LLCs, such as tried and true venture capital type investments (which do occur in LLCs more routinely than years past where companies were more frequently structured as C-Corporations), the likelihood is high that investors will demand board of manager representation rights and an extensive list of protective provisions. In these cases, it puts emphasis on the need for founders and investors to be more intricately aligned on the company's plans and objectives from the outset of the investment (such as a shared philosophy pre-investment on matters of strategy, budget, hiring, raising subsequent capital, and the eventual exit desires for the company).
The protective provisions in LLC operating agreements can significantly impact the rights of both the founding members and investors. The appropriateness for various protective provisions often depends on the stage of the company and the overall size of the investment. Regardless, founders and investors alike need to assess, understand, and appropriately draft protective provisions, which are often some of the most heavily negotiated and impactful elements of LLC operating agreements. The attorneys at Linden Law Partners have prepared and negotiated hundreds of LLC operating agreements for business owners and investors at all stages of the company's business life cycle. Contact us today to discuss how we can help.
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