Common Mistakes in Agreements
By Michael Freeman | Acacia
The governance document mistakes that cause the most damage are rarely exotic. They are straightforward drafting and process failures that accumulate overtime until something forces them into the open. At that point, correcting them is expensive, slow, and sometimes impossible without the cooperation of parties who are no longer cooperative. Identifying and avoiding them at the outset is considerably more efficient.
Using Generic Templates Without Customization
The internet has made it easy to find operating agreement and bylaw templates, and many of those templates are structurally sound as starting points. They fail in the specifics. A template written for a generic two-member LLC may have voting provisions, distribution mechanics, and buyout triggers that do not reflect anything the actual parties agreed to. When those provisions are invoked in a dispute, the fact that they came from a template rather than actual negotiation is irrelevant. They are the governing terms.
The most common template-related problems include voting rights provisions that do not match the parties’ actual intention, distribution provisions that default to equal splits when the capital contributions were not equal, management authority provisions that are either too broad or too narrow for the actual operating arrangement, and missing buy-sell provisions that leave no mechanism for handling a member exit. Customizing the template to reflect the actual deal is not optional; it is the point of having the document at all.
Failing to Execute the Documents Properly
An operating agreement or set of bylaws that was never signed, or that was signed by some but not all of the required parties, is questionable as to enforceability. This sounds obvious, but it happens routinely. The entity is formed, the documents are drafted, and then the execution process gets set aside while the business moves on to other things. Months or years later, a dispute arises, or a bank requests the signed documents, and the signature pages are either missing or incomplete.
For corporations, the failure to hold the initial organizational meeting and document it through meeting minutes is a related problem. The organizational meeting is where the initial directors are confirmed, officers are appointed, the bylaws are adopted, the initial shares are issued, and any initial business decisions are ratified. Skipping this step leaves gaps in the corporate record that can complicate later actions and that courts and creditors sometimes use to argue that the corporation was never properly constituted.
Proper execution means every required party signs, signatures are witnessed or notarized where the governing documents require it, and the executed documents are kept in a central location along with the other entity records. For corporations, this typically means a corporate records book or binder that holds the formation documents, bylaws, meeting minutes, and share ledger.
Not Updating Documents as the Business Evolves
A governing document that accurately reflected the entity at formation may be substantially out of step with the entity two or five years later. New members have been admitted. The original manager has stepped down. The business has pivoted to a different activity. Capital contributions have been made that were not accounted for in the original document. A member’s interest has been transferred informally, without following the transfer procedures set forth in the operating agreement.
Each of these changes, if not properly documented through an amendment to the operating agreement or through a formal corporate action recorded in the minutes, creates a gap between what the documents say and what actually happened. That gap is a liability. It weakens the entity’s governance posture and creates ambiguity regarding the parties’ rights and obligations.
Amendments to operating agreements and bylaws should be treated as formal actions, not informal emails or verbal agreements among the members. The amendment process should follow whatever the document specifies (typically a written amendment signed by all members or by the required majority), and the amendment should be kept with the original document as part of the entity’s records.
Inadequate Dispute Resolution Provisions
Many operating agreements and bylaws say nothing about what happens when the members or shareholders cannot agree on a fundamental decision. In a two-member LLC where both members have equal voting rights and the operating agreement requires unanimous consent for major decisions, a deadlock means the business cannot move forward on any matter the members disagree on. If the agreement provides no mechanism for breaking that deadlock, the practical options are limited to litigation or a negotiated buyout, neither of which is efficient or inexpensive.
Deadlock provisions can take several forms: a designated tiebreaker (a third party, an independent director, or a specific individual named in the agreement), a mandatory mediation or arbitration process, a put-call mechanism that allows either party to trigger a forced buyout at an agreed-upon price, or a dissolution trigger if deadlock persists beyond a certain period. None of these is perfect for every situation, but having any one of them is considerably better than having nothing.
Arbitration clauses are common in commercial agreements and increasingly common in operating agreements and bylaws, particularly where the parties anticipate that disputes would be expensive to litigate in court. A well-drafted arbitration clause specifies the governing rules (AAA, JAMS, or a similar body), the location, the number of arbitrators, and whether the arbitrator’s decision is binding. A poorly drafted arbitration clause can create more uncertainty than it resolves.
Overlooking Tax Treatment Implications
Governance documents do not exist in a tax vacuum. How distributions are structured, how profits and losses are allocated, whether the entity is manager-managed or member-managed, and how transfers of membership interests are handled all have tax implications that need to be considered when drafting the documents. An operating agreement that allocates losses disproportionately without a proper economic effect analysis may not survive IRS scrutiny. A distribution provision inconsistent with the entity’s elected tax treatment creates filing complications.
This does not require making the operating agreement a tax document, but it does require that the tax implications of the governance provisions be reviewed by someone who understands both the legal structure and the tax treatment before the documents are finalized. Fixing a governance document provision that has been in place for several years and that has generated inconsistent tax reporting in the meantime is a considerably more complicated problem than getting it right at the outset.
Acacia works with clients to identify and resolve governance documentation issues as part of entity structuring and compliance work. For broader commentary on entity governance and structuring, MichaelIoane.com is a useful resource.
The information in this article reflects general structural principles and practical observations from consulting experience and is provided for educational purposes only. It should not be interpreted as individualized legal or tax advice.