I’m commonly asked about the speed of forming a limited liability company (LLC). Clients are often happy to learn that LLCs are quick and easy to form, and can generally be formed in a day or two. LLCs have few formalities, no double taxation, and little maintenance requirements. For those reasons, many clients opt to use LLCs. But these assets can result in a pitfall: people often move through the process so quickly they fail to stop to make sure that all the co-owners are actually agreed on key issues. Owners may later find themselves bound to terms that they did not and would not have agreed to at the outset, or involved in a lengthy and costly negotiation or litigation. If you’re forming or already part of a company with other members, you’ll want to ask yourself (and your partners) – have we agreed on these key issues?
1. Who Is Steering The Ship?
An LLC can be managed on a day-to-day basis either by the members or by a select group of managers, who can be members or non-members. If decisions are going to be made by managers, then the process for appointment, resignation and/or removal of managers should be agreed on.
Sometimes there are major decisions, such as a sale of assets, adding members, or taking on a large amount of debt, where members want a higher threshold for approval. Majority owners usually want these decisions made at a threshold that doesn’t require all (or sometimes any) of the minority owners to approve. Minority owners may see the protection afforded by these “supermajority” decisions as one of the few controls that they have on the operation of the company. Usually these percentages are set at a level high enough that a clear majority of owners need to agree, but less than unanimity, so that one recalcitrant member with a small stake cannot grind the process to a halt. The decisions that will require supermajority approval, and the threshold needed, all should be agreed at the outset.
When there are multiple owners involved in the day-to-day running of the company, I often counsel clients that it’s reasonable to have some supermajority threshold that prevents one majority owner from making all the major decisions, but doesn’t require the approval of so many of the smaller owners that it would impact the ability to move quickly in the event of an extraordinary event. On the other hand, if the company is really one founder’s baby and the other owners are small or passive investors, the founder usually has a wide berth to make any and all decisions.
2. What Happens When Someone Wants Out?
Small LLCs with only a few owners often have dynamics more like a marriage than a corporate entity. The owners personally know each other, work together, and function best when they get along. Accordingly, owners usually want some protections on making sure they can control when ownership interests can be transferred, especially when the new owners may be participating in the management. There are three main types of transfers that need to be considered at the outset: (1) buyouts, (2) transfers on the death of a member, and (3) third-party transfers.
If the relationship among the owners deteriorates, or if one of the members decides he or she is no longer interested in participating in the business, it’s important to have an understanding of whether and how a member can be bought out or buy out the other members. Including this process in the operating agreement can avoid years of dispute and significant legal expenses. For example, there could be a “put” provision that allows a member to either sell his or her interest to the remaining members or purchase all of the remaining members’ interests. Of course, in the event that the parties are still on good terms when someone wants out, they don’t need to follow these provisions, and can always agree on different terms. However, these provisions provide a failsafe in the event that the situation turns fraught.
Because LLCs are often owned by individuals, it’s important to address the situation where one owner dies. One option is for the LLC to allow for the estate to be a “permitted transferee,” with limited voting rights, but full economic rights to any distributions. The LLC operating agreement may also state that the members have a certain amount of time to purchase the estate’s interest.
True arms-length third-party transfers of less than a majority interest in an LLC are somewhat uncommon (other than certain types of holding companies with mechanisms for distributions). Most purchasers don’t want to be locked up in an illiquid investment in an operating company in which they don’t have control. However, it’s important to address this situation, at least in basic terms. Some agreements flatly prohibit these transfers without the approval of the other members. Other agreements allow only for the transfer of the economic interest (not any management interest). Other agreements allow for transfers, but grant the company a “right of first refusal” with regard to repurchasing the ownership interest on similar terms as are offered by the third party. Each of these can be the right choice, as long as all of the owners know what it is going in and are comfortable with the restrictions.
3. Who Provides Services, And For How Long?
When all the parties are initially contributing money, initial contributions are fairly straightforward. However, when some members are contributing services, it becomes important that the parties agree on exactly what the services are going to be, what the time commitment is (per week or month), and how long the commitment will last. It’s not unusual that if a business is struggling, an owner whose contribution is in ongoing services will start to look for other opportunities; disagreements can arise over whether that owner has fulfilled his or her obligations to be vested with the ownership stake.
4. What Happens If The Company Needs More Money?
The owners should also agree whether the company is going to have the right to require the members to add more money if necessary (a “capital call”). Often the various owners of an LLC will have very different financial tolerances for contributing additional funds. Trying to resolve these issues at a time of the LLC’s financial distress may further deteriorate a working relationship. The parties need to have these discussions early so that all owners know what to expect if more money is needed down the line.
5. Can The Members Compete?
If the owners of the LLC are also going to be the individuals running the entity, then they may want to consider whether to have certain restrictive provisions, such as non-compete and non-solicitation provisions in the LLC operating agreement. Passive owners in the entity, or owners providing similar services to multiple entities, may not want to be bound by these restrictions, so whether to include these provisions will depend upon how the members structure and fund the entity. In most cases, owners of an LLC who are also running the entity should be subject to some form of a non-compete, whether it’s in the operating agreement, in a confidentiality agreement, or in an employment agreement.
While many owners want to try to minimize formalities and move quickly at the start, making sure that the owners agree on the above issues at the outset and put their agreement in a written document can dramatically reduce the costs of resolving any disputes later on.