I have many clients who are investors who ask for information about setting up a Limited Liability Company to hold the property, which is always recommended to protect yourself. However, most clients do not ask the appropriate next question – do I need an operating agreement? If you have a partner or partners, I would strongly recommend it. An operating agreement spells out who has the authority to do what, what type of action requires a unanimous vote, what capital contributions each partner is contributing, how the company will take on new members, along with a number of other items. Addressing this now can prevent problems in the future.
Addressing this now can prevent problems in the future. Edward Schenkel
I have litigated cases concerning partners who are fighting over how to manage the property or whether to sell the property, and so forth. An operating agreement can prevent problems down the road and can help maintain a smoothly operated partnership.
When considering an operating agreement, here are some of the more important things to think about.
1. Do you want the real estate company to be “member managed” or “manager managed”
In Connecticut, a limited liability can be set up as a “member managed” company or “manager managed” company. A member managed company generally requires the members to vote on taking action. A manager membered company is essentially set up so that a manager is vested with authority to run the operation of the company and the other members are more or less passive investors.
An operating agreement can be used to specially dictate what authority each member has in the day to day operation (e.g can unilaterally approve expenditures under $100) and what type of actions require a majority or unanimous vote (e.g. expenditures over $1,000 or the decision to sell or buy property). Similarly, an operating agreement can provide how a manager’s authority is limited and what requires a unanimous or majority vote of the members. Whether to make the company manager or member managed depends on the company.
2. Breaking a tie vote if two members
I have set up a number of limited liability companies for two member companies. While having a less amount of members may have a number of benefits, such as making decisions faster than larger companies, there is one issue that the two members must decide – what happens if there is a tie vote? This is something that each two member (or even number member investment team for that matter) should think about. One suggestion is if there is an individual that both trust, that individual can serve as a tie breaking vote.
3. Taking on new members
Another decision an investment team should think about is how the company will decide to take on new members.
Perhaps the members do not want to allow the possibility of new members and if so such should be stated clearly in the operating agreement. If the members do want to allow the possibility of taking on new members, this should be stated in the operating agreement. If they do want to allow the possibility, the members should state what is required to take on new members (e.g. majority vote; unanimous vote, etc). This will prevent problems down the road.
4. Conveying a member's interest
Should each member be allowed to convey their interest without any restrictions? This could be problematic for a member who thought s/he would be working with other members. Therefore, it a good idea to clarify whether each member has the right to sell their interest without restriction or whether the other members should have the right of first refusal.
5. Who is responsible for What / Who has Authority to do What.
Another very important thing to discuss is what members have the authority to do what. If every little action of the company required a majority or unanimous vote, it could make operating the company cumbersome. That is why it is a good idea to spell out what members can do without the other partners consent, typically the smaller stuff (e.g. contract with contractors for expenditures under $1,000, etc.) and what requires a unanimous consent (typically the larger stuff such as taking on a new mortgage or buying new real estate). The more detailed this part of the operating agreement, the less likely you will have problems down the road.
6. Duty not to compete?
Many investors have their hands in different things, many involving real estate. Sometimes, a partner can be a partner in a different real estate investment company. Do you and your partners want to have any restrictions on competition if a member owns interests in other companies? Maybe or maybe not. It is worth discussing with your partners.