Wednesday, September 1, 2010

Put Your LLC Operating Agreement into Writing

As I have mentioned several times in the past (here and here), LLCs, while very useful for general business purposes, are generally discouraged when a company is planning on seeking institutional venture capital.  However, despite this general discouragement, folks keep forming LLCs.  This blog post contains some words of advice for those folks.

PUT YOUR OPERATING AGREEMENT INTO WRITING.

That is the short version.  Here is the longer version.  In Delaware, the state supreme court has determined that, if you have an unwritten arrangement involving an LLC that cannot be performed within one year, that arrangement is unenforceable. 

For example, say you get together with your other two founders and decide “Hey, it would cost money to hire a lawyer and draft a written operating agreement for our new LLC that we formed on LegalZip.  We’re all buddies.  Let’s just agree and shake hands to split the equity in thirds and to vest the equity with a one year cliff and then monthly over two more years.  That way we all have incentive to stick around.”  Boom, unenforceable.  A Delaware court would likely rule that all the equity was fully vested from day one.  This is not good if you are the founder that sticks around after the other two flake out and go back to grad school.

If any of you are junior legal achievers, you might point out that your LLC was formed in Kansas, not Delaware.  So what do you care what a Delaware court says?  Honestly, that is a relatively good point.  Unfortunately, the State of Delaware has a long history of being the “go to” state for corporate formation.  This means that their laws are very well developed in this field – much better developed that almost any other state.  Consequently, most other states look to Delaware law for guidance when they come across interesting issues like this one.  So, even if you are in Kansas, you may still be out of luck.

The moral of the story is, put your agreement into writing.  This is almost always the moral of the story, but it is especially relevant to your LLC.  Even if you and your co-founders type up some notes and all sign at the bottom, you would usually be better off than having nothing.  As Samuel Goldwyn said “a verbal contract is not worth the paper it is written on.”  

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Dividends and Preferences by Hank Heyming is licensed under a Creative Commons Attribution 3.0 United States License.