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:
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:
Is Your Business Member Managed or Manager Managed?
The Operating Agreement must spell this out.
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.
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
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:
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 in 1995 with Science degrees in Logistics, Marketing, and Business Administration. Juris Doctor, 1999.
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