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Operating Aggrements

Your Operating Agreement

An Easy Way to Show First-in-Class Business Quality

Investing in a customized operating agreement tailored to your crypto business is an easy, inexpensive, permanent method of increasing company value. Better still, a tailored Operating Agreement avoids the problems waiting for unsuspecting companies that use “canned” operating agreements.  

What does an Operating Agreement do?

The Operating Agreement is the key foundational framework for your business. It governs the rules by which your business operates. It lays out the basic rules your employees must obey. It sets out how your business expands. Its is the playbook for how a business shuts down, who gets what … and how much.

Your Operating Agreement gives confidence and impacts the price to those who would offer you riches to merge, acquire, or buy your business. The Operating Agreement protects the owner’s personal assets.

The Essential Ingredients of an Operating Agreement

Every business Operating Agreement needs to address certain key business aspects.  These include:

  • Equity Structure includes who all contributes what to the business. Will there be different types of owners with different roles? How are the capital accounts set up? How are profits distributed? What is done with the physical property of the business?

  • How Decisions are Made: Who makes decisions and what different types of employees/managers make different types of decisions needs to be set out. How are managers selected? How are managers and employees removed?

  • Voting: Different types of business owners may have different types of decision making authority based upon the particulars of the business.

  • Liability for Risk: Different types of owners, executives, and employees incur different types and degrees of risk, based upon their role and involvement with the business.

  • Accounting: Each company should have an official corporate book, containing the essential files and other materials of the corporation. Each business must keep certain kinds of records for certain time periods. Those records are kept by specified employees. These record-keeping details will differ from business to business.

  • Anti-Dilution Terms: Businesses tend to grow and expand with success. Each owners relative share of power and interest in the company is preserved with anti-dilution language.

  • Transfer of Owner Power: Most businesses do not end up with their original owners still controlling the company. People come and go; and with different people come different personalities, philosophies, and abilities. The details and circumstances of ownership control transfer needs to be specified.

  • Non-Compete Agreements: The business needs to ensure that its critical executives and employees do not take the skills, and knowledge learned at the business to become a competitor. The operating agreement should incorporate the business’ non-compete agreement.

  • Non-Disclosure Agreements: Most businesses have confidential information, processes, and strategies essential to business success. The operating agreement should incorporate a non-disclosure agreement.

  • Proprietary Information and Invention Assignment Agreements: The founders, owners, and employees are the persons who came up with the ideas, practices, and business secrets that create profits and value for the company. The company needs to ensure that it owns these ideas, practices, and business secrets and not the individuals who came up with them. This is because those individuals were acting in their role as a company agent at the time of creation. The operating agreement should incorporate the company’s proprietary information and invention assignment agreement.

Five Key Questions the Operating Agreement Must Address

Lack of thought is the central mistake in the adoption of an Operating Agreement.  Those who run the business must adopt an Operating Agreement and think:

  • Does this apply to my type of business?

  • Does the agreement apply to the size of my business?

  • Does this agreement apply to how the business leadership wants to run the business?

  • If everything goes our way, does this operating agreement reflect our best-case vision?

  • If circumstances go against the business, does the operating agreement resolve conflicts or wind down the business how we want?

Is Your Business Member Managed or Manager Managed?
The Operating Agreement must spell this out.

  • Member managed businesses​ are like pure democracies. Each member voting rights to directly and actively manage the business in proportion to each member’s share of ownership, irrespective of their expertise, experience, or knowledge. It is the concept of “Might Makes Right.” Member managed businesses are controlled purely by the voting power and ignore other factors.​

  • Manager managed businesses​ are like a classic Republic. The members use their voting rights (the corporate shareholders or LLC members) to delegate business governance to a person or small group of persons whom they trust to make decisions on their behalf. Manager managed businesses are controlled by executives who are elected or removed by the voting power of the members.​

Operating Agreement Management Mistakes

One function of an operating agreement is to specify who makes decisions and how they are obligated to make them.  The drafting must be clear and unambiguous.

  • What is the authority of each manager?

  • What decisions need approval from higher managers or a Board of Directors?

  • What type of decisions does manager authority encompass?

  • Bankruptcy?

  • Winding down the business?

  • Acquisition?

  • Sale?

  • Merger?

  • Sale of key assets?

  • Deadlock breaking? (when equal managers do not agree)

  • Delegation of tasks between managers

The Operating Agreement must make clear how these corporate governance challenges are resolved.

How will you Allocate Profits? The Operating Agreement decides.

An “allocation” refers to how money income earned as business profits is distributed to owners. It refers to accounting. It refers to taxes.

Profit Allocation Operating Agreement Procedures Protect Personal Assets from a Lawsuit

Your business accountants will require documentation to verify how business profits are allocated. Giving out business profits as you deem appropriate without following a process spelled out in an operating agreement opens your personal assets up to lawsuit collection. The failure to follow operating agreement profit allocation procedures is evidence to support a piercing the corporate veil lawsuit.

Profit Allocation Operating Agreement Procedures Protect from Scrutiny from Those Who Might Disagree

The Operating Agreements offer “cover” for business owners, employees, and investors when profits are allocated in a manner in which they will disagree.

Distribution - Operating Agreement Procedures Govern the Handling of Physical Property and Physical Funds

An LLC member with a forty percent share of a proof of work cryptocurrency mining business cannot show up one day and take possession of forty percent of company ASICS computer servers.
A person may be the ten percent stockholder of a cryptocurrency ATM business.  However, the ten percent owner  cannot take ten percent of the fiat currency in the machines.  These are examples of “distributions” and the operating agreement spells out how they are handled.
Tax concerns are important considerations with respect to operating agreement distribution policies.  An owner may be deemed to have received taxable income from a distribution even though no actual profit was received by the owner.  In this instance, the owner gets a tax bill but did not benefit from an actual distribution of value to the owner to cover the tax liability.  This is codified into law at 26 USC § 704.   The operating agreement should include language so that the owner is not tax-prejudiced through business distribution language.

Two Profit Allocation and Distribution Approaches

There are two philosophical approaches to Operating Agreement Profit allocation:

  • The Layer Cake

  • The Targeted Allocation

These two approaches if properly applied can satisfy tax safe harbors.  In other words, this language in an operating agreement can decrease corporate liability and thus increase owner profits!

Targeted allocation profit distribution attempts fail to achieve tax safe harbor status.  This is because the businesses liquidate with a cash waterfall that targets income and thereby does not satisfy IRS provisions.

Layer Cake profit distribution attempts have a better track record.  Layer Cake efforts look directly to §704(b) terms, liquidate with positive capital accounts, and otherwise achieve tax safe harbor status.

The layer cake approach allocates profits and loses according to a set of tiers outlines in the operating agreement.  Distributions to owners/members/shareholders occur consistent with the capital balance of the business’ accounting books.  The technical concept is that §704(b) profits or losses determine cash distributions.

Targeted Profit Allocation

The most common approach for tax preparation language in operating agreements is the targeted allocation approach.  This dominance will likely continue.  Though, targeted allocations either do not work or fail to fit the particular type of business in many instances.  This is why lawyers and tax professionals are hired to work out these details.   It saves business tax liability and increases profits.

For Targeted profit allocation, business profits and losses are allocated according to a hypothetical liquidation event based on a waterfall specified in the operating agreement.  Care needs to be taken in drafting operating agreement targeting profit allocations.  There are tax advantages; however, poor drafting can lead to circular logic that renders the operating agreement profit allocation language meaningless.

Each capital owner’s account is equal to the amount that would be distributed in liquidation if all business assets were sold on the open market, i.e. their §704(b) value.  Each owner’s share of the minimum business gain is then subtracted from the liquidation value.

How will Losses be Distributed? The Operating Agreement decides.

Corporate stockholders, members, and owners tend to get along when business is expanding and profits flow.  Conflicts abound when losses occur.  Executives get accused of playing “favorites.”  Old grudges reappear.  Emotional wounds fester.  Operating agreements that are so often ignored become critical during hard, lean times.

Will the Business Potentially be Sold?
Will there be a Potential Merger, or Acquisition?
Your Operating Agreement Must Address these Factors.

Businesses exist primarily to succeed.  This typically means expansion, and profits.  Business success and expansion often leads to industry consolidation, where companies are sold, acquired, or merged with the founders receiving wealth from the sold value of the ownership interest.

The Crypto / Blockchain industry is an excellent example of the sale/merger/acquisition trend.  The average Crypto merger/acquisition deal was $52.7 million dollars in 2020 and $179.7 million dollars in 2021.  Forty one percent of crypto merger and acquisition deals occurred in the Americas with thirty five percent of Crypto deals in EMEA and twenty five percent in Asia.

Giving the large size of merger acquisition deal value, operating agreement language regarding those deals becomes a critical owner investment.  Changing the operating agreement when the offer begins will be too late

The Put

A “Put” provision in an operating agreement allows an owner to force the business to purchase their ownership interest at a specified value.  Put terms protect the owner from reinvestment risks.  Put provisions also protect an owner from business default.

Achieving Full Business Value:  The present value of a business takes into account expected future profits, and asset value.  An owner with a “Put” option has the power to postpone the sale all or a portion of the business.  This may add to the value the owner gets for selling their share of business ownership so that the sale takes into account those future profits and increased value.

Speed: A “Put” option can facilitate the speed of the sale, merger, or acquisition as both parties are assisted with a more accurate, less speculative business sale value.  This is because the call option has the advantage of being in the future with knowledge of what the profits and value actually turn out to be.

Owner Nostalgia, Business, and Team Loyalty:  Call options can include that certain business employees or teams are kept in place for a specified amount of time after control of the business is transferred.  Owners with a “Put” option can keep a portion of control of the business to ensure all their hard work is preserved in accordance with their original vision.

The Call

A “Call” provision allows a person the right to force the sale of company ownership under certain circumstances.  Traditionally, when a larger company buys a smaller company, the buying company gets 100% of the purchased company for 100% of the purchased company’s value.  The smaller, purchased company owners/executives are then paid to assist in the transition.  The call option assists this process in several ways:

Motivating the selling owners/executives: The purchased owners may no longer have sufficient incentive once they are paid a large amount for their company ownership shares.  Call options can hold a certain number of company shares back.  If the selling owner/executive’s post-sale performance results in continued business success, that owner can receive a specified amount of value for their held-back ownership shares.  These types of call options are especially useful for high risk mergers and acquisitions.

Tax Benefits:  Liability to a taxing government may be reduced if the sale, merger, or acquisition occurs over multiple tax periods, rather than in one lump tax time period.  A Call option in an operating agreement can provide tax benefits for the parties.

Debt Structuring: It is typical for the buying company in a sale, merger, or acquisition to take on debt (borrow money) to complete the transaction.  Call options drafted into an operating agreement can spread the transfer of ownership over a time period, thereby transferring the payment of the debt obligations over time.  This can assist the terms (cost) of the debt.  Debt structuring through a “call” option can help with business cash flow.  Debt structuring through a “call” option can achieve tax benefits.

Trial lawyer Matt Hamilton graduated from the University of Missouri – Columbia in 1995 with Science degrees in Logistics, Marketing, and Business Administration.

Matthew J. Hamilton Juris Doctor & Crypto Lawyer