An interesting lesson about how detailed strategic allocation of resources in pharmaceuticals can influence the crafting of an llc operating agreement rental property for rental properties, in a way, is what I write about after helping create LLC operating agreements for rental properties in New York. Toxicology consultants, like myself, have to consider allocation levels of various inputs and outputs when managing drug development programs. The strategic allocation of these resources determines the level of risk to be taken in a drug development program, which will ultimately determine whether or not the program will survive to at least get to a Phase I study, which in turn will determine whether the drug will ever be sold.
There are parallels to this with the realm of real estate in New York, and those are seen when crafting an LLC operating agreement, which is where limited liability companies (LLCs) fit into the picture. A limited liability company is a business entity for treating investment properties. The LLC provides an owner with a legal security system that limits the owner’s personal exposure to liabilities. Managing members of an LLC for an investment property should take the lessons that drug developers learn in the experimental setting and apply them to the real estate world.
Without getting too scientific, drug development programs in large pharmaceutical companies involve strategic action. These strategies focus on the allocation of various inputs and outputs that will lead to the best outcome for the drug developers. This process involves maximizing the effectiveness of the money being spent on a drug development program. In other words, each dollar must be spent wisely on the most pressing needs of a development program.
To provide an example of this, a large pharmaceutical company will take a thousand compounds initially to develop a drug. Starting out, the drug developer has a budget of $100. However, only those compounds that show the greatest promise of becoming a drug will be developed and moved onto the next round of funding. The “winning” compounds are not necessarily the most promising of the thousand compounds in the initial screening phase, but rather those that are still worth funding, i.e., still eligible to become a drug. The number of compounds that remain after the first round of funding has decreased from 1,000 to 100. This process is repeated four more times before a final compound is chosen to move into the clinical trials phase, and a drug developer may only have ten compounds remaining.
At this point, the drug developer has expended all $100 of initial funding and now must strategically allocate any additional funding to the 10 compounds. Assuming each compound is equally likely to make it to the next level (a bit of a leap here), the drug developer will reallocate an additional $100 to each of the 10 compounds. The strategic allocation of finances to these compounds will significantly reduce the perceived total risk that the drug developer took on by the time it reaches clinical trials.
The main point of this discussion is that drug developers are taking advantage of a series of progressive eliminations that in effect maximize the outcome of each dollar spent. The same approach should be taken when crafting an operating agreement for an LLC. Each new provision or clause that is introduced to the operating agreement should be evaluated carefully based on its cost. This cost could be the amount of legalese that is added to the document, which could result in a complex operating agreement that is difficult for the members/owners to understand. The cost could also be the unintended result that may occur because of the rights being granted to one or a group of members/members. Each provision or clause that is added or removed from the operating agreement may result in significant production loss (the LLC Members being tied up in litigation), or a reduced income (in cases where payment is involved). LLC Members/owners should be strategic in crafting the terms of their LLC operating agreements because a poorly drafted agreement runs the risk of causing a loss.
A significant risk of not putting the time and effort into crafting a detailed LLC operating agreement is that the agreement will not protect the members/owners. Without the operational guidance that an LLC operating agreement provides, the LLC members/owners are left without a clear choice of action. Often, most disputes between members/owners of an LLC pertain to a lack of communication with each of the parties. Members/owners who do not understand the terms of the LLC operating agreement may view the terms in a different light than the other members/owners. Such circumstance leads to disagreements, dissatisfaction, and could lead to one member/owner terminating the LLC.
The process of crafting an LLC operating agreement for a rental property requires LLC members/owners to have a grasp on a few basic concepts relating to the property, the business, and the members/owners. The first step in crafting an LLC operating agreement for a rental property is for the members to appoint a manager to handle the management of the property. In New York, there are several potential management systems available to an LLC. Each has different advantages and disadvantages as well as tax implications. LLC members should not choose a management structure from the few generic descriptions that are available on the Internet. Rather, members should explore the options available to them with an attorney who is familiar with rental properties. The type of management and the resulting tax implications can significantly affect the members’ returns in the long run.
A second important step when crafting an operating agreement for a rental property is to consider what will happen to the LLC if one of the members decides to leave. Does the departing member have a right to sell his/her interest at fair market value? Was the value previously placed in the operating agreement, or is it now the sole discretion of the remaining members? Properly addressing these issues in an operating agreement can save time and money down the road when it comes time to avoid litigation.
A final step that uses strategic allocation of a resource is to carefully consider the election of tax treatment. In New York, an LLC has three possible ways of being taxed: as a sole proprietorship, a partnership, or a C-Corporation. LLC members should understand what exactly is meant by each of these terms and should have an understanding the ramifications of each choice. A corporation has a double-tax system that will tax the LLC on its profits as well as the members for having received them. On the other hand, an LLC can be taxed as a sole proprietorship and be subject to a single tax. Members should take care to explain the implications of each system to each of the members and should strategize the selection of the tax election.
By applying these strategic concepts to the crafting of an LLC operating agreement for an investment property, the LLC members are ensuring that they are maximizing the impact of each dollar spent while ensuring that the LLC will continue into the future. In the same way that a drug developer will screen out 999 of a thousand compounds from its development program, LLC members should take care to screen out as many solutions to operational issues as possible. Those solutions that do make the final cut will be those that add the most benefit towards the management of the property while assuring the maximum protection for the LLC and the members.
Takeaways: Being strategic in the management of a drug development program will maximize the impact of investments in the development. In the same manner, being strategic about crafting an LLC operating agreement can maximize the return on that investment. Take care when drafting an LLC operating agreement and have the agreement undergo a thorough review by a real estate attorney.
For more information on LLCs and their benefits, you can visit Wikipedia.