Due Diligence for Start-up Accelerators and Private Equity Funds - It's all about the Operating Agreement

Due Diligence for Start-up Accelerators and Private Equity Funds - It's all about the Operating Agreement

If you’re a company hoping to receive an investment from an angel investor, start-up accelerator or VC fund, it’s a good idea to get your company’s governing documents in order prior to shopping for investment.

If you’re a LLC, then the operating agreement is the rule book of the company. It defines how the company will be managed, how decisions will be made and how and when distributions will be made.

Because of the flexible nature of LLCs, the contents of operating agreements can vary widely. All that said, it is easily the most important document for a LLC, which is why it is often the first document an investor wants to review. The following protections will no doubt be required:

  1. Preemptive Rights. Preemptive rights grant the existing members of the company the right to purchase their proportionate share of any new securities issued by the company. This is a very important protection for investors because it protects them from dilution in the event of subsequent equity raises. If the company decides to sell more units in the future, the investor can purchase its proportionate share of the new units in order to keep the same ownership percentage of the company.
  2. Right of First Refusal. This provision requires a member who wants to sell its units to offer the units to the other members (and often the company) prior to selling them to a third party. With a right of first refusal, the investor will have the opportunity to increase its ownership in the company by buying a selling member’s units prior to those units being sold to a third party.
  3. Tag-Along Rights. Tag-along rights protect the members who have a minority stake in the company in the event the majority of the members decide to sell their units to a third party. The founders of a company often are able to retain majority ownership of the company when they raise money.
    So, this provision means that if the founders find a purchaser to buy their majority interest in the company, the investor can require that such purchaser buys their minority interest as well. It protects the investor from being left holding interest in a company that the founders have sold.
    Incidentally, Drag-Along Rights, though not as important to investors as Tag-Along Rights, are important to include in an operating agreement. Drag-Along Rights is the converse of Tag-Along Rights. It means that if the founders find a purchaser to buy all of the interests of the company, and the majority wants to sell, the majority can force the minority to also sell to the purchaser.
  4. Financial Reports. Any investor will require a periodic disclosure of the financial statements of the company. For most, quarterly reports are required.
  5. Schedule of Membership Interests. A schedule, which shows the members of the company, the number of units they own, and their respective ownership percentages should be attached to every operating agreement. This is the equivalent of a cap table for a corporation. However, because LLCs often don’t use certificates to prove unit ownership, this schedule is the only evidence of the ownership of the company. Therefore, it’s accuracy is of the utmost importance to investors (and every member of an LLC).