Avoiding LP and LLC Agreements Most Common Drafting Mistake

I have been asked on numerous occasions to draft either a Limited Partnership (“LP”) or Limited Liability Company (“LLC”) agreement for many different types of business arrangements.  One of the first discussion items deals with the economics of the specific transaction that the parties are entering into.  What the parties describe as being simple to them does not necessarily mean that it is.

For example, if two people are starting a business and are contributing the same amount of money, and participating equally in the management of the busines, the LP or LLC agreement is not that difficult to draft.  Change the facts that only one person is contributing the money and the other is providing his or her service only and then you have a is a much different transaction resulting in different outcome on the dissolution of the business venture.  In that situation the person contributing the money generally wants a preferred return until he or she gets his money back. This is when I like to use the numerical approach discussed below to make certain that everyone is on the same page.

I often give the parties certain articles to help educate them about why their particular transaction may be more complex that they intially thought.  In an excellent article written by Terrance F. Cuff he explains the common mistakes that attorneys make by trying to draft a LP or LLC agreement as cheaply as possible.  Not surprisingly the biggest mistake is not understanding the economics of what the parties are trying to accomplish.

Terrance F. Cuff explains attorneys can easily do harm when drafting partnership and LLC agreements by making compromising mistakes.Below, he explores what can happen when the drafter decides to draft an agreement quickly and cost-effectively, while failing to consider a partnership’s complexities and subtleties regarding the economic and tax-oriented provisions in LP or LLC agreements.

Getting the Economics Wrong.  The most serious way in which a drafter can compromise a partnership agreement may be to get the economics wrong. Indeed one of the most important drafting objectives should be to get the economics of a deal right. The task of getting the basic distribution economics right can be easy in a simple 50-50 deal.But the drafting task can become vastly more complicated as the partnership agreement introduces tiered returns, preferred returns, and returns based on internal rates of return. Tax distribution and other special distribution provisions also complicate partnership economics.

Economic adjustment provisions triggered by defaults on capital contributions can further increase the difficulty of getting the economic deal right. Also, admitting new partners midway through the deal, or, admitting service partners who receive profits interests, can complicate the economics. Providing for buy-out rights, put rights, liquidation rights, or expulsion rights are other factors that may complicate partnership economics. It is not surprising then that drafters often do not quite get the economic deal right—for any of a number of reasons. Moreover, some manage to get the economic deal dramatically wrong.

Disputes among partners based on partnership economics are common. The the parties should consider how it could later be proved that:

  • The economics of the partnership agreement was properly explained to the to the parties.
  • The the parties understood the economics.
  • The parties approved the economic scheme reflected in the partnership agreement.

Numerical Examples.The parties should consider working through all of the economic provisions of the partnership agreement, testing each of these provisions with numerical examples. These should include both normal examples that are consistent with economic expectations. Some of the provisions to test include:

  • Normal distribution provisions for cash from operations.
  • Distribution provisions for cash from capital events.
  • Distribution provisions for cash from financings and refinancings.
  • Distribution provisions for liquidation of the partnership.
  • Preferred returns.
  • Tax distribution provisions.
  • Provisions that adjust capital accounts and partnership economics on defaults on capital contributions.
  • Economic provisions regarding the redemption or retirement of a partner.

It is useful to have the partnership’s accountants undertake similar tests, and to circulate spreadsheets with numerical results. Consider the possibility of attaching numerical examples as exhibits to the partnership agreement. These numerical examples can provide guidance to accountants and others in interpreting the partnership agreement in the future. Also, these examples can be useful if there is later litigation concerning the economics of the partnership agreement.

In drafting economic provisions for a partnership, the drafter should not confuse distributions of cash with allocations of income and loss. Provisions governing distributions of cash generally should be separate from the provisions for allocating income and loss. Mixing provisions for distributions of cash with allocations of income and loss invites misadventure.