But First, the Operating Agreement

With all of the money on the table in the cannabis world these days, deals are coming together fast and furious. Not all of them are Constellation/Canopy scale, and plenty of these deals are getting done in the six-figure range.

It’s tempting to move fast. Everyone else is moving fast. There is risk in not moving fast. For investors, it’s always possible to lose a deal to someone who does not hesitate to pull out the checkbook.

A recent case from the Delaware Chancery Court highlights some of the perils of moving too fast. In this case, the business operator’s dreams, and his investor’s hopes, were vibrant and bright in August 2014.

The investor pulled out his checkbook, spent at least $150,000 of cash, and was left holding the bag as the venture collapsed before his eyes - in under two months.

Did anyone get a written operating agreement in place? Of course not.

Did they spend the next three years arguing about it in court - only to have the judge tell them that everyone would swallow their own losses, and that no money would exchange hands? Yes, indeed.

The Venture

In August 2014, Jeff Hoops ran into his old friend and classmate Jerry Neal at a high school reunion. Jerry operated his own insurance agency, and Jeff was a prolific purchaser of insurance. He operated Revelation Energy, a mining operation that did over a million dollars in business every day.

They hatched a plan. Jeff would essentially buy out Jerry’s insurance business, and get a significant discount on insurance for his mines and for himself in the process. Jerry would have a steady customer, overhead paid for, and he would still be free to pursue as much additional business as he could find.

Reality did not match the vision that the two men had painted in their minds.

Jerry completely failed to get Jeff’s mines their insurance - and in fact left Jeff’s mines without insurance for more than 24 hours, while concealing the issue from him, and demanding payment for his work in “obtaining” the insurance.

Jerry also tried to renegotiate their handshake deal at every step of the way. He repeatedly confirmed the agreement in writing, and then explained why this would work, or that would never work, why he needed more money up front, and more.

He refused the help he needed, rebuffing the offers from Jeff and his highly-experienced staff.

The Critical Error

Jeff made a critical error. He had his lawyer write up an operating agreement for the new LLC, and an employment agreement for Jerry - a great start.

But agreements are generally only good if they are signed, and Jeff didn’t get Jerry’s signature on either.

Instead, Jeff went ahead and spent about $150,000 to get the business up and running. He even paid Jerry a $75,000 commission on those phantom insurance policies - even after Jerry, unfathomably, allowed coverage on Jeff’s mining operations to lapse.

The Result

Predictably, Jeff and Jerry’s business divorce ended up in court.

Jeff filed his lawsuit against Jerry a year after the deal blew up. Jerry filed a countersuit. More than three hundred documents were entered into evidence, and testimony was taken from six witnesses in a three day trial.

Unknown but nonetheless consequential is the time, money, and energy of the parties that was consumed in even getting to trial.

The court found that Jerry mislead Jeff, the largest single customer of the business, when he told Jeff that his mining operations were covered when, in fact, they were not.

The court was not convinced by Jerry’s claims against Jeff. They found Jeff to be credible, and Jerry to be full of hot air.

But, at the end of the day, the court told both parties to go their separate ways - without any additional money changing hands.

But First, the Operating Agreement

Three years of litigation to get a judge to tell everyone to go home and put the past behind them is an enormous investment of time, money, and emotional energy.

If recent headlines are correct, Jeff’s energy business is having some serious troubles. One wonders if his time and energy would not have been better spent focusing on his core business, and letting this one slide.

And, what if he had gotten an operating agreement first? They could have included a mandatory arbitration provision, and limits on discovery in the event of a dispute or disagreement.

Hindsight is 20-20, and it is easy to second guess. But situations like this should also inform business decisions of those who prefer to learn from the mistakes of others.

For those who are made of money and who do not mind letting bygones be bygones, maybe proceeding without a written operating agreement for the LLC is just fine.

For the rest of us, for whom six figure investments are still meaningful and significant, there is a lesson to be had: get the written operating agreement signed before writing the check.

Otherwise, assume you’ll never see the money again. At least then, you won’t be disappointed.

Read the Delaware Chancery Court’s full opinion here.

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