Operating Agreements can be difficult to navigate, but a few sections done well can elevate the working relationship between Limited and General Partners

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Most operating agreements between General Partners and Limited Partners/Syndicates are customized, to a certain extent, to each investment. However, there are many common items in each of them, some of which might be critical to a successful partnership. Continue below to see what we have found to be some of the most integral parts to our operating agreements, particularly with 506(c) single properties.

Customizable and Flexible

One of the most powerful aspects of a good Operating Agreement (OA) is an ability to quickly flex and customize to myriad preferences of each major partner. When an OA is not only tailored from inception but also allowed to adapt to future challenges, it is considered strong and professional.

Purpose of the Company

Be sure to make it broad enough that you won’t need to edit it mid-ownership. For example, a few years into the project the General Partner (GP) might need to remodel. A broad “purpose of the company” clause will allow an expeditious remodel without requiring a separate vote from the Limited Partners (LPs). Including a paragraph that allows any and all actions that the manager deems in the best interest of the company can also help operations flow more smoothly.

Clear and Reasonable Voting Rights

Votable Issues

In some OAs, Class A members are the non-voting, limited partners, and in other OAs, Class B members are the non-voting, limited partners. Sometimes the non-voting class can vote for a select number of major issues, like changing the allocation schedule or removal of a manager if they are able to gather a majority of votes based on percentage interest in both the Class A and Class B members, which can be quite difficult if not impossible at times. Other times, the non-voting class has absolutely no voting weight for any issue.

For a successful OA, make sure that the major partners are in support of whichever voting arrangement is made. Some LPs might see those voting rights as potentially destructive to the LLC, especially if they take time and focus away from a Manager in which they have confidence. On the other hand, some LPs feel more at ease having some voting latitude if the Manager makes decisions that are not in the best interest of the LLC. An example of a possible clause could require a whole majority vote based on percentage interest (both Class A and Class B members combined) to remove a Manager for cause, if the unfortunate need should ever arise, during a sanctioned company meeting.

Votes to Alter Allocation Schedule

Another Class A member voting clause which can be found in some OAs allows say over changing the allocation/waterfall schedule or approving a loan to the Manager. This vote sometimes requires that Class A and Class B member groups must have a majority vote of percentage interest in each class to approve such changes or loans/guarantees, again during a sanctioned company meeting. Since the Manager will have often 50% of the total votes of the entire LLC, these votes can only pass if both the Manager and a majority of the Limited Partners agree. Again, time spent in customizing this part of the OA can save a material amount of money and disputes should conflict arise in the future.

Limited Liability

Naturally, in a real estate LLC, the company enjoys limited liability. However, a thorough OA will reiterate that limited liability, both in the article that addresses the Member’s duties and rights and the article that does the same for the Manager.

Allocation Schedule

The Allocation schedule will most likely be tailored to each deal, depending on several factors. The Allocation schedule (allocation schedule can also be called a distribution agreement or waterfall schedule) on the OA should mirror the allocation schedule explained in the Private Placement Memorandum (PPM). Often OAs have a section verbally explaining the allocation amounts and waterfall hurdles as well as an Exhibit at the end of the OA reiterating the Allocation schedule.

A well written allocation schedule section will align its verbiage with the actual payment schedule, e.g. the net cash flow payable is accrued and then distributed quarterly. The OA will generally contain the most granular explanation of the order of distribution payments as well. For example, the section on Allocations might explain how, after the preferred return is paid out, Net Cash Flow is allocated in several contingent steps, first paying members who absorbed proportionate losses, then to those who and then paying members based on pro-rata share of initial capital contributions. Below is a sample of on of our OAs used for a office property:

Net Profit and similar items for any taxable year shall be allocated as follows:

first, to the Members in proportion to, and to the extent of, the excess of prior allocations of Net Loss, in proportion to their relative Membership Units, over prior allocations of Net Profit under this section for the then-current taxable year and all prior taxable years;
second, to the Members in proportion to, and to the extent of, the excess of prior allocations of Net Loss, in proportion to their positive Capital Account Balances, over prior allocations of Net Profit under this section for the then-current taxable year and all prior taxable years;
third, to the Members in proportion to, and to the extent of, the excess of prior allocations of Net Loss, in proportion to their relative Membership Units of Capital Accounts with a zero balance, over prior allocations of Net Profit under this section for the then-current taxable year and all prior taxable years; and
fourth, to the Members in proportion to their relative Membership Units.

Net Loss and similar items for any taxable year shall be allocated proportionally among the Members as follows:

first, to all Members in proportion to, and to the extent of, the excess of prior allocations of Net Profit under over prior allocations of Net Loss under this section for the then-current taxable year and all prior taxable years;
second, to the Members in proportion to their relative Membership Units until the Capital Account of any Member is reduced to zero;
third, to the Members in proportion to, and to the extent of, their positive Capital Account balances; and
fourth, to the Members in proportion to their relative Membership Units.

As you can see, this granular schedule clarifies payments in times of severe losses or steady gains. A reliable OA helps lay out most plans of actions for most contingencies that an investment may face.

WaterFall Hurdles

In times of positive cash flow, OAs also delineate the compensation of the manager, usually based upon fees and waterfall hurdles. A common allocation/waterfall schedule for stabilized private equity real estate is three tiered: the first being a pro-rata (per pi su) annual return up to a preferred return, often between 5-8%, the second being a split (70/30 is common) of the remaining cash up to a certain return figure for the investors.

For example, a 70/30 tier would mean that after the preferred return of 7% is paid out on a pro-rata basis, then 70% of the remaining net cash would go to the LPs up to a 12% return that year, and the 30% remaining net cash is distributed to the Manager/Sponsor. If there is any net cash available after that tier is satisfied, then the third tier activates. That tier often is a clean split between LPs and the Manager. For example, this third tier/hurdle could be 50/50, which would mean that 50% of the remaining cash would go to the Limited Partners and 50% would go to the Manager/Sponsor.

Allocation upon Sale or Refinance

A clear OA will have a separate section delineating the allocation schedule in the event of a sale or refinance. Often this clause simply continues using the same tiers as annual cash flow, but sometimes this clause call for a a simple split between Limited Partners and the Manager, sometimes as a 50/50 split where 50% of the sale profits, after all capital contributions have been returned, is allocated to each the Limited Partners and the Manager.

Call Option Clause and Transfer Clause

One purpose of the operating agreement is to clarify operations for expected events, yet another possibly more critical purpose is to clarify operations for unexpected events, like transferring of ownership interest or call options. In the less likely event that a member wishes to divest of their ownership, an OA needs to clearly define the steps needed. A right-of-first-refusal, which is similar to the right-of-first-option, gives the Manager the first choice in buying the members interest. If the Manager chooses not to purchase it, the member’s interest is then offered to other members in the company.

Another less likely possibility is an event with a call option. This is where the manager has an option to buy out at any time any member for any reason for a pre-designated premium, sometimes double the preferred annual rate. Though not typical, this clause allows for the manager to buy out high maintenance investors or buy more interest in the property early for whatever tactical reason.

Personal Liability on Non-Member Loans

An issue of great importance in the operating agreement is the type of loans the company will allow from outside sources, namely non-recourse or personal liability. Though the agreement will specify where the Manager has full discretion over when to obtain funds and how much, the LPs will need to sign off on whether those loans will hold the Members personally liable or not. Personal liability on loans means that the members personally guarantee the loan based on their personal funds, in the event that the Company’s funds cannot cover the debt service. Non-recourse loans contain the liability of the loan to the Company only, protecting the Members from any responsibility or liability even if the Company cannot cover the debt service. Personally guaranteed loans have lower interest, fewer restrictions, and fewer nuances than non-recourse loans.

State Laws

An OA will repeatedly refer to the LLC as following the laws and statues of the state in which it is incorporated. The state of incorporation can be in the state of the property or in a LLC popular state like Delaware, Wyoming, or Nevada. Since state laws are not specifically found in the OA, Managers and their legal teams will need to be familiar with those laws and policies of their own accord.

Wrap Up

Operating agreements can be tedious, expensive, and time consuming, but the upfront investment on a thorough OA can clarify most events upfront, save money in the future, and facilitate a smooth LP/Manager working relationship for years. Tailoring your OA, whether you are an LP or a Manager, in ways that make you not only legally protected but also financially advantaged can be an investment in itself.