In the past two years, several Service Disabled Veteran Owned Small Businesses (SDVOSB) and Veteran Owned Small Business (VOSB) applicants for inclusion in the U.S. Dept. of Veterans Affairs (VA) Vendor Information Page (VIP) database have received denial letters from the Center for Verification and Evaluation (CVE) because of wording in their operating agreement. The most common reason for denial is language requiring unanimous consent to amend the agreement itself or adding members to the LLC. The VA’s Office of Small & Disadvantaged Business Utilization (OSDBU) posts its official position on operating agreements here.
However, the Limited Liability Corporation (LLC) Acts of 23 States and the Uniform LLC Act require that Operating Agreements be amended only with the unanimous consent of the members. A similar number of States require unanimous consent of the members to add or disassociated members after the filing of origination documents.
This unanimous consent requirement by the States makes sense when you consider that Operating Agreements are corporate governance documents, but also serve as a contractual agreement between the members. If a member is added or removed, the equity interests of at least some of the other members necessarily changes. Also, the voting paradigm shifts for any proposed changes to the firm.
Imagine you and three of your closest friends set out to start your new dream gig owning your own widget manufacturer. Now imagine, you live in a State that allows the Operating Agreement to dictate how the agreement will be amended and yours doesn’t require unanimous consent for amending. If two or three of the remaining members, i.e. your partners, decide to amend the agreement and allow an additional member into the LLC, there is very little a member with a minority interest could do about it, unless you own a majority interest.
However, as a minority interest owner, even if the addition of a member doesn’t lower your ownership percentage (no LLC Act I am aware of will allow that to happen without the member’s consent), it could affect your influence in the firm and ultimately your voting rights.
All of the States I surveyed that require unanimous consent of the members to amend an operating agreement either limited unanimous consent to that issue and the amending of the originating documents (i.e. Articles of Origination) or to an otherwise short list of items. In virtually every State, most decisions could be made by a majority in interest in the LLC or by a majority of managers elected by the members. The VA wants to ensure that the SDVOSB or VOSB maintains control of the LLC and doesn't lose control of it to others.
The universal exception in the States that allowed amendment without unanimous consent was “unless otherwise provided in the Operating Agreement or Articles of Organization.” Translated, this means the Operating Agreement the members sign when they formed the LLC is of extraordinary importance. For this reason, when any of the lawyers in my firm are tasked with drafting an Operating Agreement and representing the majority interest owner, the lawyer strongly advises the other members to seek independent counsel to review the agreement before signing.
Operating Agreements Akin to Prenupital Agreements
I have often likened the Operating Agreement to a prenuptial agreement. At the time of the signing, everyone likes everyone else and everyone is imagining marital harmony for ages to come. Unfortunately, like many marriages, a huge number of start-ups fail and an even bigger number suffer some kind of dysfunction or lack of harmony. Carrying the marriage analogy to its natural conclusion, dysfunction among the members often translates to disharmony and acrimony throughout the rest of the organization.
A well-drafted operating agreement can work to lower the likelihood of dysfunction by spelling out members’ rights and responsibilities. It can also incorporate clauses that make disassociation painful for those choosing to leave or trying to force members out of the LLC. If you have questions about your LLC’s operating agreement, consult an attorney at Whitcomb, Selinsky Law PC or your State’s LLC Act. Please call (303) 534-1958 or complete an online contact form.