Defining a Subscription Agreement

A subscription agreement is a written agreement that is used mostly in the securities transactions to denote some type of investment. Whenever a company seeks an investment, they look for someone to purchase ownership interests in the company. Ownership interests generally would be represented by membership interests (for an LLC) or shares (for a corporation). Once the investor agrees to make an investment with the company, the agreement that companies and investors enter into is often referred to as a subscription agreement.
As noted, this is an agreement commonly used in conjunction with an investment by an investor in a company or one of its funds. The investor "subscribes" for the interests that are offered by the subscription agreement, hence the name. If the investment is being made as part of a securities offering (this is often the case), the Subscription Agreement is typically accompanied by a Private Placement Memorandum or Securities Offering Memorandum , which are required disclosure documents that are used in connection with the offering of private placements designed to sell securities to investors. Such documents are required if a registration exemption is being utilized, which is most often the case and an L.L.C. limited liability company generally does not issue securities, so the operating agreement may suffice as the governing document.
It is important, however, to note that in many cases, the Subscription Agreement will be a standalone controlled document, even if there is a Private Placement Memorandum (PPM) or securities offering memorandum (SOM) being offered contemporaneously with the Subscription Agreement. This is because the subscription agreement provides an investor with advanced information about the investment, including any restrictions on the ability to transfer interest, the purchase price and the investment amount, warranties or other representations about the entity, and the voting requirements applicable to the interest being purchased.

Overview of an Operating Agreement

The operating agreement is an important legal document for a limited liability company. Under Delaware law, the operating agreement may be part of the certificate of formation so that Delaware LLCs are not required to enter into a separate operating agreement unless the parties desire a more complex agreement.
The operating agreement governs:

  • management of the LLC
  • the rights, powers, and preferences of the LLC’s members
  • the rights and powers of LLC managers (if applicable)
  • the fiduciary duties of members and managers
  • the procedures for admitting new members
  • distributions to members
  • transfer of membership interests
  • dissolution and winding up

Operating agreements are important not only because they set forth the rights and responsibilities of the parties, but also because they will govern in the event of a dispute among the parties regarding the ownership, operation, or policies of the LLC. If there is no operating agreement or if one does not address a particular issue, the relevant statutes will determine the outcome of the dispute. If there is an operating agreement, however, the parties will be bound by its terms. Therefore, it is important that the parties reach agreements concerning the rights of the members with respect to such issues as compensation (including cap-table dilution), member meetings, transfer of membership interests, and the desire for or right of first refusal upon a proposed transfer of LLC assets.

Differentiating Subscription from Operating Agreements

The core differences between a Subscription Agreement and an Operating Agreement are primarily structural, in terms of usage and in the contract parties involved. In general, Subscription Agreements are standalone documents, separate from any LLC or corporate documents, that explain the terms, conditions and situations for investors to purchase an equity interest (either equity securities such as shares of stock, or a greater ownership interest such as an LLC membership interest). As a result, they are often called share purchase agreements (if the equity interest is a share of stock) or unit purchase agreements (if the equity interest is an example of an LLC membership interest.) These agreements set forth the basic terms for the purchase and sale of the equity interest between the selling and buying parties.
An example of this is the following: John Smith decides to open a restaurant so he issues 1,000 shares of common stock for an offering price of $10 per share, and Richard Jones agrees to purchase 100 of these shares for a total investment of $1,000. Smith will need to draft a Subscription Agreement that will set forth the operating terms, contingencies, warrants, representations and warranties, and other various terms that are necessary to sell these 100 shares to Jones. The agreement would be between Smith (as seller) and Jones (as purchaser). As listed below, there are many specific terms that would be present in this kind of Subscription Agreement.
In contrast to a Subscription Agreement, an Operating Agreement is often included in the Articles of Organization for an LLC (but can be a separate document as well), and sets forth the LLC’s organizational structure, management, members, and other requirements as determined by the members. For example, Mr. Smith above would file an Articles of Organization that list his name, business name, members, purpose and other typical items. He should also have one or more operating agreements dividing the equity interest among the members (i.e. shareholders), the management structure (i.e. who manages the business, and how) and other appropriate items for compliance under his local state law. In this scenario, let’s say that Smith and Jones form an LLC together – it would then be appropriate for them to craft an Operating Agreement between them setting forth their members, their percentage of interest, management structure, and other corporate matters.
The following is a partial list of the general differences between a Subscription Agreement and an Operating Agreement:
This is a very general overview of some of the key differences between a Subscription Agreement and an Operating Agreement. There are certainly other requirements, uses, parties, and situations between the two contracts that will vary from situation to situation. It is always prudent to remember that your state law may require certain terms and conditions in both contracts, and specifying these particular terms may require a longer contract than usual.

Legal Considerations and Implications

Subscription agreements and operating agreements impose certain legal liabilities and offer specific protections to the parties involved. A subscription agreement, which is primarily a sales contract for securities, generally outlines the terms of sale between a company and an investor. It provides the necessary language to ensure that the securities being sold are exempt from being registered with the SEC and thus helps prevent any regulatory liabilities. Common legal issues include management class liability and Section 16(b) liability .
An operating agreement, on the other hand, is used to establish and outline the relationship, rights and responsibilities among the LLC members, which may be individuals or other legal entities. While it can be a simple document (especially if all members are friends or family), it needs to address member and management liability, ownership transfers, dissolution and winding up. It can also address management class liability and Section 16(b) liability.
Both documents are important legal documents for companies to have in place, and lack of either can prevent litigation from advantages.

Usage and Application for Each Agreement

As discussed below, the decision between using a subscription agreement or an operating agreement is a complicated one that depends on a variety of factors. A business must consider its specific needs, circumstances, and structure to determine which form of agreement is more appropriate.
Below are some factors you should consider:
• One determining factor whether to use an operating agreement or a subscription agreement is whether you have already raised money for your business. If you do not need to raise additional funds on the same terms as prior round investors and you expect future rounds of financing will be on different terms (e.g., rights preferences), then it may make sense to use an operating agreement going forward.
• Another factor is whether the company has already granted equity awards to employees. If the company has done so, at least the relatively short term prospects of the company are likely known and unlikely to change in the near future. In this case, it may make sense to use an operating agreement to document the terms.
• A third factor is whether there are any other material changes in the company’s status or future business plans. These changes may include: (1) a different business model than originally proposed, (2) a different class of investment than originally proposed, (3) dilution to current investors, or (4) the pricing of the next round of financing. This demonstrates that the subscription agreement was short-sighted and does not address the now considered important factors. Accordingly, an operating agreement to address these issues may make more sense in this context.
• One final factor to consider is whether it remains necessary to continue to use a subscription agreement to raise funds each round of financing. If so, the subscription agreement may outweigh the disadvantages discussed above.

Case Studies and Examples

A closer look at real-world examples will help illustrate how to best use subscription and operating agreements in practice. For example, there are a myriad of multi-member LLCs that have been operating without having formal agreements in place – this may be the result having not known they were needed or having the intention to put one into place, but forgetting about it all together. In that situation, if an investor wants to come on board and put in substantial capital in exchange for an ownership interest, they would expect to see some sort of written agreement. A multi-member LLC currently operating without such an agreement would need to have a subscription agreement entered into with the investor, and from a general best practices perspective, the LLC should also enter into an operating agreement with them. However, to the extent that a multi-member LLC is the "Primary Issuer" of its own membership interests, but is doing so through "investment clubs," those investment clubs are already going to be doing some of the subscription agreement work. This raises the question of whether the "Primary Issuer" should be the multi-member LLC itself or should it be those investment clubs. With regard to investment clubs that intend to be active in investing, as opposed to pooling funds and having one person make all the investments, it would be best for them to be treated as the "Primary Issuer," having subscription agreements put in place with the members of the investment clubs, and entering into a subscription agreement with the parent multi-member LLC – followed by each investment club entering into an operating agreement with the LLC . This will ensure that any issues arising from the inclusion of additional parties are isolated. In the alternative, if the investment club structures are not going to be active, and are similar to passive public non-listed REITs, the multi-member LLC currently has in place – or should have in place – an operating agreement that allows them to conduct business in the way intended.
Another area to consider when structuring subscription and operating agreements is registrants and exemptions. Multi-member LLCs that can be treated like private companies typically do not have to file reports with the SEC on a periodic or ongoing basis. However, if a multi-member LLC happens to be considered a "publicly traded partnership" under Section 7704, then it would be subject to the filing requirements under the Securities Exchange Act of 1934 and the periodic reporting requirements under the Investment Company Act. Further, multi-member LLCs that offer interests to investors outside of their state of formation might be subject to state registration requirements in addition to SEC requirements.
As a general best practice, there are a number of considerations a multi-member LLC should keep in mind when entering into agreements: