For family businesses organized as limited liability companies, an operating agreement is critical to maintaining ownership within the family, providing clear direction to management in the face of complicated family dynamics, and offering stability when individual family members wish to exit the business. This post will touch on a few of these concepts.
An operating agreement can maintain ownership within the family by appropriately restricting the ability of members to transfer their interests in the company to persons outside of the family. Family businesses frequently prohibit transfers absent the consent of some or all of the other members, and a transfer without such consent will usually give the other members or the company the right, or in some cases the obligation, to purchase the transferring member’s interest.
By like token, a family business should consider whether to freely permit transfers among family members and entities owned by family members (e.g., family trusts or wholly-owned LLCs). Such provisions should coordinate with the founding members’ estate plan. As a mechanism to avoid conflict, a family may consider granting members who desire to exit the family business the right to sell their interest back to the company or to the members. To avoid a cash crunch, family businesses might also consider including a fair process to raise additional capital from the members.
A mature family business, or a business with diffuse ownership interests, should consider including a drag-along rights provision. Generally, drag along rights permit a majority of owners to require minority owners to join in a sale of the company on the terms negotiated by the majority, thereby preventing minority interests from obstructing an otherwise attractive sale transaction. Drag along rights can benefit a family business by providing an exit route approved by a majority of family members who no longer wish to continue the family business while protecting the minority interest holders by ensuring they participate in the sale on the same terms as the majority.
Preserving Effective Management
As ownership of a family business fractionalizes over time, the operating agreement should preserve management’s ability to operate the business without being hamstrung by intrafamily dynamics. Tools here include issuing nonvoting interests to members who do not actively participate in the business, granting management broad authority manage day-to-day company affairs, and restricting the types of matters subject to a member-wide decision. Family companies should consider appointing not only the current managers but also their successors. If the company is managed by more than one manager or by a board of directors, the operating agreement should include an efficient and fair mechanism to resolve deadlocks.
Without a solid operating agreement, conflict and other circumstances can cause significant damage to a family business, including loss of control of the business. A thoughtful operating agreement will go a long way to mitigate such harm and serve as a steady hand as family dynamics change over time. As always, planning ahead is crucial.
Nate Somers is a business transactions attorney at MPBA and serves as corporate counsel for many closely-held and family-owned companies at all stages of the business cycle. He routinely advises companies at all stages of the business cycle including entity formation, governance and succession planning, and the preparation of operating agreements, buy-sell agreements, and equity incentive agreements. He also continues to practice complex commercial litigation focusing on sophisticated contract and merger and acquisition issues. He can be reached directly at email@example.com.