About a month ago my husband Matt and I were sitting in a real estate closing. We were doing the typical “closing” activities. We were busy signing paperwork and keeping an eye on our 10 month old. (Yes, our little guy has already been to two real estate closings!)
We had one of our three real estate attorneys with us during the closing.
SIDE NOTE: Yes, we actually work with three real estate attorneys. Some might think we are crazy, but each attorney has a different expertise that we utilize in our business. One has a specialty in evictions. One has a specialty in buying large apartment buildings. The other one is terrific at the day-to-day real estate issues that arise. We have found having a team of experts around us very beneficial as we have grown.
Okay, now back to the real estate closing….
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How I Learned the Importance of an Operating Agreement
Somehow, we got on the topic of LLC’s, annual meetings and operating agreements. For most real estate investors, this is not the most exciting topic. However, our attorney and I got into a discussion that led me down an interesting path.
Annual meetings had come up in our discussion.
So I asked our attorney, “How do you know if it is necessary to even have annual meetings?”
Then my attorney turned to me and said something that stuck with me, “It actually depends on what exactly is spelled out in your operating agreement about meetings. Your operating agreement dictates what you should and should not be doing in the company. You don’t want to be ignoring any of the governing rules in your operating agreement. Remember, the operating agreement protects your limited liability status.” In short, this meant that to keep the liability protection of the company, we had to actually do what it says in our operating agreement.
As I drove home from the closing, I kept thinking about our attorney’s comments. He really made me stop and think about how confident I am about our current agreements.
I spoke to Matt and asked him if he was clear on the “governing rules” of all of our operating agreements. Since I did not get a straight answer, I decided to embark on the fairly detailed, but important project of reviewing each and every one of our operating agreements.
The reason I wanted to review all our operating agreements is not because I am an attorney, am bored with nothing to do or even because I like doing a lot of detail work (because I really don’t!). However, we have been growing quickly in the last few years and subsequently continue to purchase more and more properties with various partners. To date, we have over a dozen Operating Agreements. So as I embarked on this project and am still working on it today, I wanted to share some learnings that might help you in your real estate business…
5 Factors You Need to Consider About Business Operating Agreements
1. Actually Have an Operating Agreement
I have come to understand that operating agreements are not required in all states.
Actually, in the state of NJ, where we do most of our real estate investing, it is not required that we have an Operating Agreement. However, I am so glad that we began utilizing Operating Agreements in 2004.
Operating Agreements have so many benefits that include clarifying the structure of your company, protecting your limited liability status and governing the actual rules of your company. It is imperative to have this type of clarity when you have anyone else involved in the business — spouses, partners, etc.
No one wants to think about, “What happens if this partnership does not work out?” and would rather simply have a “handshake agreement.” However, this shortcut is a mistake.
Having an Operating Agreement in place (not just a handshake) will help ensure everyone is on the same page while the business is active, as well as if the business has to be dissolved for some reason. Many of our operating agreements even include a death clause in case one of the partners passes away. Again, this is something you don’t want to think about or consider, but life, as we all know, keeps moving, and you want to protect yourself and everyone involved in your company from the BEGINNING!
2. Create a Practice to Review Your Operating Agreements Once a Year
As I reviewed the first few LLC Operating Agreements we created, I soon found out that we mistakenly never updated our registered office in one of our first LLC’s that was formed in Pennsylvania.
We originally began investing in PA, so it made sense at the time that we used our PA address as the registered office. However, we thought we updated this, and it turned out that we had not.
Although this was a simple oversight, this could have been avoided if we had a practice in place to review operating agreements once a year. You better believe we will begin instituting this practice moving forward.
3. Be Wary of Online Templates
As I reviewed our 10-plus agreements, I realized very quickly that every time my husband formed a new operating agreement with a NEW partner, he also created a NEW operating agreement each and every time!
As I was reviewing all the different operating agreements, I realized we had so many different “templates.” Real estate investors need to be careful and cautious when utilizing “online templates.”
Listen, I know that it is sometimes cheaper to simply pull something off the internet and call it “good.” However, I would not make that mistake when creating an operating agreement. I would be very careful that the online template complies with your state and local laws.
Moving forward, we now have one template for LLC operating agreements formed with strategic partners and one template we use only for LLP operating agreements with equity investors.
4. Make Sure to Actually Do Everything in Your Operating Agreement
Okay, this one might seem obvious.
However, through the years I have experienced a lot of real estate investors simply using “online templates,” which they have never fully reviewed. During my review of our operating agreements, I found that some of our operating agreements did not even mention annual meetings. Some of the earlier operating agreements did mention annual meetings. One actually called for an annual meeting on a specific day every year!
Again, we can’t be all over the place with annual meetings or anything in our agreements. We need to be consistent.
Most of these operating agreements discuss capital contributions, financial distributions and record keeping of financials. The specifics of these topics will change from agreement to agreement. However, there are sections of the agreement that should remain consistent that way you can ensure everything in that agreement is being executed.
The quickest way to open yourself up to liability is to act as if the operating agreement is just a formality and that it is not being used to run the business.
5. Consider Having an Attorney Help
We now use a very knowledgeable attorney who helped us create the in-house “templates” I was discussing earlier in the blog post. He has been very helpful to include sections of the operating agreement that will protect us and all of our partners.
We first brought him in to help us create the LLP (limited liability partnership) operating agreement. This is the type of entity we use with our equity partners. All of these equity partners have put in a financial contribution, and the operating agreement spells out from A-Z how their financial contributions will be handled, the general structure of the company and percentage of ownership.
This is an important one. It is important and quite honestly imperative to have in writing what percentage of ownership each partner will have in the company.
Our attorney included parts of the LLP operating agreement that we would never have thought of ourselves or even find in some online template we purchased for $50. Of course, engaging an attorney is perceived to be more expensive. But I would argue it is more expensive not to include an attorney.
I heard a wonderful real estate teacher once say, “Pay for good advice. You either pay now or pay later. I would rather pay now!” There is a lot of truth in that statement.
Bottom line – I would caution you to take your business operating agreements seriously. Don’t just use something that you did not review closely to go through the motions.
This operating agreement can help you if you let it do so!
Do you currently have a business operating agreement? Did you draw it up yourself or use an attorney? Would you add anything to my list?
I’d love to hear from you in the comments section below!