As a syndication attorney, one of the core documents that I provide pretty much every single one of my clients is an operating agreement. What is an operating agreement for syndication or an investment fund? What needs to be in it? What are those elements? How do I know if it’s any good? Let’s talk about all of that in this video.
So, if a private placement memorandum is kind of the disclaimer document that explains the investment opportunity to investors, then an operating agreement is really the rules that govern how that syndication, how that investment fund is going to work. It is an absolutely critical document, not only because it’s required, but also because it’s what you turn to at the end of the day to make sure that you’re making your decisions in accordance with what the investors need to get.
So, it’s that instruction manual. Like I said, I like to call my operating agreements, “all-weather operating agreements.” The reasoning is because I want to make sure that if it’s rainy weather or sunny weather, they can look in the operating agreement and find out exactly what is supposed to happen, and all of that’s been provided to the investor, so there’s no questions later on. If there’s a question on why the distribution is X, Y, Z, you can point to the operating agreement and say, “Remember when I gave you this document? Here’s exactly where it says that.”
That’s the whole point of the operating agreement—it’s an agreement on how you’re going to operate. Funny name, huh?
So, one of the key points that needs to be in an operating agreement is the roles. And those roles are oftentimes twofold. On one hand, we have the different kinds of members that there will be, so we have members that are going to be the investors. Right? So, in an LLC, by the way, we have members; we don’t have shareholders.
So, those members are going to be the investors. But then we also have another class of members, which is the managers or the managing members. And it’s really important to have a distinction between those two because that outlines who’s making the decisions and who’s more passive.
This becomes extremely important in the way that you’re operating your syndication or your fund because those managers or managing members are often the ones that are doing all the work, while the members are sitting back and waiting for distributions. And so, those roles, that governance, is absolutely critical to outline.
Another key point that we need to have in our operating agreement is what those decision-making processes are going to be. So, who’s going to decide what, and when do the investors get involved?
Typically, in most of my agreements, the investors don’t really have that much involvement. They are usually involved in one or two key things: 1) they are involved when it’s time to remove the manager. That’s one of the really big things, but they don’t have involvement day-to-day. They are usually involved when it’s time to replace the manager, which is very rare, or if we’re selling everything, it’s time to vote.
So, that decision-making is a critical point that we need to make sure is clearly outlined in the operating agreement, and that includes how we’re going to make those decisions.
Another key point is the distribution structure. That needs to be outlined clearly so that there’s no confusion when it’s time to actually make those distributions. We want to make sure that everybody knows how much is going to the managers, how much is going to the investors, and what kind of waterfall structure is being implemented.
Waterfalls are a whole separate topic that could take an entire video to explain, but basically, they outline how the profits are distributed. And that’s really important because it goes hand in hand with how you incentivize the managers to keep the project successful and ensure the investors get their returns.
So, to wrap things up, your operating agreement needs to be thorough. It needs to cover all the key points like roles, decision-making, and distributions, so everyone knows exactly what’s happening from day one. This document is critical for ensuring that the syndication runs smoothly, everyone knows their place, and there’s a clear set of rules that governs how the investment operates.