There’s an old saying that is just as true in business and investing as it is on the sporting field:
“If you are going to play the game, you have to know the rules.”
If you are participating in a private investment via a Limited Liability Company (LLC), then an LLC Operating Agreement is like the rule book – it should tell you what you need to know about how the LLC is structured, managed, and operated. As an investor, it is important to understand the rules of the game to protect yourself and reduce your risk.
Investing via a Special Purpose Vehicle (SPV)
There are various ways to invest money into a startup company, by direct investment, through a fund, or using a structure called a Special Purpose Vehicle (SPV). As the name suggests, an SPV is a structure created for a special purpose, which in this case is to pool funds from a number of investors to invest money as a single entity (often referred to as a “syndicate”) into a specific company. An SPV can be structured as a trust, a corporation, a limited partnership, or an LLC. In this article, we are looking at LLCs.
For more information on investing via SPVs, check out our article Investing through a Special Purpose Vehicle (SPV).
How Propel(x) LLCs work
Propel(x) enables Angel Investors to participate in startup investments by investing via a Syndicate in manageable amounts, which can be as little as $5,000.
To provide this service for its members, Propel(x) has a wholly-owned subsidiary called Planck Fund Management Corporation. It is an exempt reporting Investment Advisor in Venture Capital which creates and manages syndicate investments and is the manager for all the Propel(x) SPVs that invest in startups.
All Propel(x) SPVs are structured as a “Series LLC”. There is a Master LLC called Planck Holdings LLC that provides a common framework and operating agreement that sets the rules for all the individual LLCs that are created for individual investments or projects, each of which has its own supporting agreement.
Each Series LLC has a unique name, paperwork, capital accounts, assets, liabilities, and can have different members. The members of each Series LLC have different rights, obligations, and assets. Importantly, the individual Series LLCs have their own liability protection, whereby the assets owned by one Series LLC are protected from liability risk of other Series LLCs even though they are under a common Master LLC.
There are two key documents that set out the terms and the structure of an LLC, the Operating Agreement and the Subscription Agreement. Note that investors do not buy shares in an LLC – they buy an interest, which determines their percentage ownership and is documented in the Subscription Agreement.
An LLC can be structured as a Member-managed LLC, or as a Managed LLC. The Propel(x) SPVs are set up as Managed LLCs.
LLCs are “pass-through” entities. If there is a profit or a loss in the LLC, it will be passed on to the members. If there is a profit, members will have to pay their own tax on the earnings. If there is a loss, the members can claim that loss against their personal taxable income.
What is an LLC Operating Agreement?
An LLC Operating Agreement is a legal document describing how the LLC operates including the governance, terms, conditions, and member responsibilities. The agreement sets out the working and financial arrangements among the members and the powers and duties of the manager.
Components of an LLC Operating Agreement
The specific content of LLC Operating Agreements can vary widely, depending on the particular requirements, purpose, and function of the LLC. The key elements of an agreement should include the following:
The organization of the LLC is covered in this section, which details how the company was created, where it is incorporated, the laws under which it operates, who the members are, and the ownership share of the members.
2: Management & Voting
This section of the agreement covers the management structure and arrangements including who is the manager and what are their powers, plus the voting rights of the members such as one vote per member, or a number of votes in proportion to a unit of ownership interest.
3: Capital Contributions
Capital contributions refer to the rules and requirements relating to financial investments by the members of the LLC and how additional funds may be raised by the members.
The mechanism for the distribution of profits and losses among the members is covered in this section. For example, if the company is a Managed LLC, there may be a proportion of profit distributed to the manager as a carried interest, with the remainder then being distributed to the members.
5: Membership Changes
Documenting the rules and procedures around the addition or removal of members is covered in this section, which will deal with circumstances around new members coming into the LLC, or if a member goes bankrupt or passes away, or separates from a spouse.
Winding up a company can be a complicated undertaking, which may be required if an investment fails, or there is a liquidity event involving the sale of all the company’s assets. This section covers the process in the event the LLC is to be dissolved. It is particularly important for members to understand what happens in the event of a company failure.
An important consideration to be covered with a Managed LLC is the mechanism by which a successor manager is appointed if the incumbent LLC Manager fails.
How Do LLC Operating Agreements Affect Investors?
LLC operating agreements affect investors because they set the terms and conditions upon which an investor is able to participate in an opportunity. For example, an investment in a startup via an SPV with an overarching LLC Operating Agreement can only be made under the terms of that agreement. If an investor is unhappy with the terms, they must either choose not to participate, accept the conditions as written, or seek to change the terms of the agreement which could be a challenging exercise requiring extensive legal wrangling and the agreement of multiple stakeholders.
An investment LLC may have an opportunity to participate in a follow-on investment, in which case the agreement would detail the corresponding opportunities for members to participate in a follow-on situation.
What Are The Benefits of an LLC Operating Agreement for Operators & Investors?
There are many benefits to having an LLC Operating Agreement. One of the most significant benefits is that it clearly sets out the operation of the company, provides clarity for the members and gives them confidence that the rules of the game are established and articulated in advance. That way, if something happens, there is a level playing field and all parties know where they stand.
Another important benefit of an agreement is that it helps to solidify the status of the company as a Limited Liability Company, along with all the benefits that it brings, particularly regarding risk mitigation and liability protection.
How to Incorporate Investors in LLC Operating Agreements
A formalized and structured approach is required to prepare the LLC Operating Agreement. It is important that the agreement is written in an understandable, concise language that clearly communicates the intent and requirements of the agreement rather than in an overly complex manner using legal jargon.
The objective of an investment SPV is to facilitate capital raising activity, so it is important that the agreement supports that objective by not scaring off investors with a document that is favored towards one party or is overly complicated.
Are LLC Operating Agreements Required? Why You Should Have One Regardless
The legal need for an LLC Operating Agreement depends on where the company is incorporated. Some states require an agreement, while other states do not. However, even if not legally required, it is a good idea to have an agreement, even for a single-member LLC such as might be used for an individual to run their own company.
For an investment SPV, it is particularly critical to have an LLC Operating Agreement in place, because there may be many members, the members may be total strangers, and there is significant potential for problems to occur, especially when investing in startups. Having an agreement in place for the investment provides added protection to the members.
Tips on Drafting an LLC Operating Agreement
There are key elements that need to be included in an LLC Operating Agreement to address potential future events which may arise as an organization grows. Due to the complexity involved, while drafting LLC Operating Agreements, it is recommended to work with an attorney who is experienced with financial law and has expertise in this area.
Whether the LLC is a single-member or a multi-member group, it is important for the owners to document the rights and responsibilities of all parties involved. Equally important it is to note that investors become members of an LLC only once they invest. Thus the process of drafting an LLC Operating Agreement begins with business owners meeting with an LLC’s members to discuss items like financial assets, voting rights, dissolution, and more to keep everyone on the same page. Throughout this process, here are a few things to consider
- Provide exact definitions for key terms
- Avoid the use of exceptions (if possible)
- Use clear, definitive, and concise writing
- Be consistent with word use
- Use a present, active voice in the wording
The Need for an LLC Operating Agreement
An LLC Operating Agreement is an important document that sets out the rights and responsibilities of the members, how the company operates, and what happens in the event of a number of potential scenarios. It provides clarity and direction for the company to move forward and establishes a Standard Operating Procedure to be followed in the event of a dispute among members or between members and the LLC’s manager.
If an LLC Operating Agreement is in place for an investment, it is one of the most important documents that form a fundamental part of the deal. Reviewing the agreement is a vital step for any potential investor to take, so they can understand what they are getting into rather than being blindsided by unknowns when it’s too late.
As with any investment, past performance is no guarantee of future performance, and any investment decision must balance the risk against the potential return.
If you are interested in building your portfolio by adding investments in startups, you can find more information here on how to start angel investing and how to find opportunities for angel investing on the Propel(x) platform.