LLC Operating Agreements
The equity investment opportunities presented by RealtyMogul.com are generally structured through “direct participation” investment vehicles like limited liability companies (LLCs). An LLC is governed largely by its operating agreement, which is essentially a contract among the members of the LLC in which the details of the LLC’s operations are spelled out.
Operating agreements typically contain complex provisions governing the financial relations among the limited members and the manager, the delegation of management rights and duties, the admission and withdrawal of members, and the dissolution of the LLC, among other matters. For LLCs used in real estate investments, there are several key provisions that should be reviewed in considering how the legal structure may contribute to the overall risks of the transaction.
1. Capital Calls. There’s always the possibility that an enterprise will need more funding. It’s always preferable to negotiate the sponsor’s operating agreement to assure that any such capital calls will be optional-only. If this is done, then the consequences to investors if a capital call does occur will generally be limited to either (1) suffering some dilution of their interest (since members who do contribute will now have an proportionally more capital invested) or (2) the investor being deemed to having taken a loan, from the project company or the contributing members, at a reasonable interest rate for the amount requested but not contributed. Terms vary as to whether the non-contributing member can receive any cash distributions while any such loan remains outstanding.
2. Admitting New Members on the Same Terms. Related to the capital call provisions, an LLC manager may decide that it needs to bring in new investors in order to raise the necessary additional funds. This is generally fine as long as the new investors are being brought in under the same terms as all other investors. If the manager wants to bring in new investors under different terms, however, this should be allowed only if a “super-majority” of the LLC members (usually those constituting 70-80% of the voting power) approves of such an unusual situation.
3. Distributions. Real estate syndications are generally structured so that investors receive a “preferred return” on their investment (often in the 5-10% range), and then receive a share of the remaining cash flow and profits (typically 50-80%), with the sponsoring real estate company receiving the balance (its “promote” share). The provision of the operating agreement detailing this “waterfall” of distributions will describe the order of payouts, whether and how any unpaid amounts are ultimately recouped, and whether “tax payouts” may be required if the company’s taxable income will give rise to tax obligations of the limited members.
4. Removal of the Manager. Passive investors are usually content to let the LLC manager run with the chores of actively managing the property; but if it becomes clear that the job is really being mishandled, LLC members want some means by which the manager can be removed. At the very least, instances of gross negligence or willful misconduct should be causes for removal; most operating agreements also allow for a manager to be removed upon the vote of a “super-majority” of the LLC members, usually those constituting 70-80% of the voting power of the members. Investors sometimes do not control all of the voting rights of an LLC, so care should be taken that a vote provides the desired power in such instances.
5. Transferability of Interests. Real estate LLCs generally involve “private placements” of securities (the LLC interests), and U.S. securities laws tightly control the transferability of securities that have not been publicly registered with the SEC. In addition, the LLC’s operating agreement will often provide for “rights of first refusal” – the right of the company, or of other members, to purchase any interests that a member would like to sell. These provisions give the LLC and its members “first dibs” to take a greater participation in the project if another member wants to sell or transfer its share.
6. Indemnification of the Manager. The operating agreement of a real estate LLC usually provides that the manager will not be liable to the limited members for mistakes or errors in judgment that it made in good faith; this is similar to the “business judgment” rule providing similar leeway to directors of a corporation. The manager should not, however, be indemnified in instances of its gross negligence, willful misconduct, or uncured breaches of the operating agreement’s terms.
7. Voting Rights. The voting rights of investing members are often limited only to major events such as sales of the property or removal of the manager. It is important, however, to understand the weight of such votes. Some operating agreements provide the sponsor with 50% or more of the voting rights, so that the investors’ control rights are essentially nullified.
8. Amendments. Sometimes the manager is empowered with making very minor amendments to the operating agreement without consulting the other members; for example, to correct inconsistencies, or if legal counsel recommends adding provisions that would better protect the limited members or are needed to stay compliant with law. Anything else, however, should require at least a majority vote of the limited members, and oftentimes a super-majority vote is advisable to assure that a bare majority doesn’t adversely affect the rights of the other 49% of members.
9. Reporting and Tax Statement Timing. Most real estate syndications provide updates to their members on a quarterly basis, and sometimes more frequently in the event of major new property leases and other material developments. The operating agreement should specify the frequency and timing of these reports, and should also clarify when tax returns will be issued to investors.
10. Buy/Sell or “Forced Sale” Rights. These provisions usually arise only when a limited member has significant power within the syndicate, such as holding a majority interest in the overall syndication. In such cases, the investor may want to participate in some major decisions regarding the property (e.g., large leases or over-budget expenses). If there is then a disagreement with the manager over such a major decision, that investor may want either be able to buy out the sponsor company’s interest or else to sell its own share back to the sponsor. Sometimes the parties agree to a “forced sale” arrangement where they agree that if such a dispute arises they will simply sell the property.
Operating agreements used by in real estate LLCs can sometimes be very similar, as some degree of conformity has developed over the years. Significant variances remain among individual transactions, however, and unusual operating agreement provisions should be well understood, and the consequences assessed, as part of the investment decision process.