Jay and Pat: a cautionary tale
A person we’ll call “Jay” was in business with his partner “Pat”. The two had met because their kids were in after school activities together. It turns out Pat had a great product but lacked people skills and was not much of a salesperson. Jay, on the other hand, loved people and was born to sell. After sampling the product one day, Jay asked if he could sell the product for Pat and receive a percentage of sales. Pat thought that this was a great idea, to the point of turning around that very day day and forming an Arizona LLC (via one of those highly-advertised legal document preparation websites) and putting both himself and Jay on as its Members. Pat even reached deep into his wallet to spend an extra $100 on an “operating agreement” from that same website, printed it out and brought it to Jay. Jay went ahead and signed it without actually reading it.
Beware the online form LLC “operating agreement”
It should come as little shock that Jay and Pat’s “cookie-cutter” operating agreement neglected more than a few critical provisions dealing with the management and control of the company. For example, the operating agreement made several references to an “Exhibit A” where someone reading the agreement could find the specific membership interests of Pat and Jay, respectively. However, when you went looking for the “Exhibit A” (and I did), it wasn’t there. In fact, it turns out that the one thing that Jay and Pat could agree on was that “Exhibit A” was never prepared, let alone attached. The rest of the operating agreement didn’t offer any more clarity on the topic. How much of the LLC did Pat actually own? Or did Jay own? It was impossible to say because it was referred to but not ever spelled out.
As a result, not only was there no way of knowing who owned what in the LLC but, moreover, nobody knew if all members of the LLC were equal or were of different classes (e.g., Class “A” members vs. Class “B” members). Obviously, if all of an LLc’s members get along or can work through and agree on these questions, there is no problem. However, if an ownership split of, say, 50-50 is not what either member had in mind to begin with, this could be very problematic–and this is exactly what happened with Jay and Pat.
As it turns out, Jay was indeed a very good sales person. Getting purchase orders from a high percentage of potential buyers he got in front of. Pat, on the other hand, did little else to contribute to the business. Of course, Pat did not see it that way, believing himself to be not only the creator of the product but actively engaged in additional “product development”, as well as handling the finances of the company. Unfortunately, Pat had an overinflated sense of his business acumen. When asked by Jay to explain certain expenses and charges on the LLC’s bank statements, Pat frequently got defensive and threatened to remove Jay as a member altogether and find “other” investors. Meanwhile, Jay felt that he was now doing 90% of the legwork (and in turn generating 90% of the revenue) in the business but was now having to split everything with Pat 50-50.
Why being a “Member” officially is not good enough
In fairness to Pat and Jay, if you were to look up their LLC on the Arizona Corporation Commission’s e-Corp system, it does show both of them as Members of the company. However, it is important to understand that the ACC website does show how much of a share Jay or Pat own in the LLC. Rather, the ACC data just mirrors whatever was on the two partners’ Articles of Organization for the LLC. The fact is Arizona’s Limited Liability Company Act does not require percentage ownership interests to be spelled out in the Articles, instead reserving this important bit of information for the LLC operating agreement.
LLC ownership percentages should be spelled out in the Operating Agreement
What can you learn from Jay and Pat? First off, you should always (and I mean always) read the operating agreement for the LLC which you are joining or investing in. If you don’t understand something, find an attorney well-versed in LLC and partnership issues to read it and explain it to you. Believe me, it is always going to be easier (and for that reason less costly) to correct or clarify a provision in an operating agreement (a) when you actually know about it, and (b) before you’ve put your signature on it.
Next, while we do NOT advocate this, if you simply don’t have the time or inclination to read and understand your operating agreement (or don’t want to hire legal counsel to point out the problem areas for you), at the very least make sure that the agreement clearly spells out what your specific ownership interest is and that it matches up with your understanding of what your stake will be before you sign.
Ben Bhandhusavee is the Managing Attorney for BhandLaw, PLLC, a Phoenix business and technology law firm working with start-up companies, creative intellectual property matters, and corporate M&A and complex technology transactions. Ben can be reached at (602) 678-2970 or by e-mail at firstname.lastname@example.org