15 Considerations for LLC members

November 28, 2021

The LLC is the vehicle of choice for many small businesses due to the lax governance requirements and flow through taxation. They’re also the easy to form and most states (including New York) require minimal information at the outset of the formation process. By result, many LLCs are formed using either a template LLC Operating Agreement that the members don’t read, or with no Operating Agreement at all. Important issues are then governed by a template that the members have likely not read, or are governed by default by the state’s limited liability company law. In New York the default is that LLC matters are decided by majority vote (based on members’ ownership percentage) - this may not be how the members intend the company to be run, but in the absence of an agreement to operate the company based on unanimous agreement, the majority rules.

In many instances, clients approach us seeking assistance with the drafting of an operating agreement for their LLC. This usually happens when they’ve already formed the LLC and have been operating it for some time without any agreed framework that lays out the rights & responsibilities of members, how the entity is governed, whether members have the ability of members to sell/transfer their membership interest, and without a mechanism to address deadlock. We being by asking questions that seek to establish:

1

Management – manager managed or member managed?

LLCs can be managed by the members (i.e. the owners), or they can be managed by a specific manager, or a board of managers - managers can be, but often aren’t, LLC members. “Member managed” LLCs are more typical for small, closely held businesses where the members all play a role in the operation of the company. Manager managed LLCs are more common where one of the members agrees to be primarily responsible for running the business, and/or where it is envisioned that a non-member will be hired to run the business, much like the CEO of a corporation,

2

What will be the ownership % of the members?

For the most part, membership ownership percentages match profit interests, so a member who owns 25% of the company is entitled to 25% of the company’s profit (when distributed). Other permutations are possible however - e.g. a member could own 25% of the company, but be entitled to 40% of the profits. This often arises where particular members allocate more of their time to the LLC than others, or brings particular expertise to the LLC.

3

What are the members contributing to the LLC?

New members typically contribute one or more of cash, property/equipment and services (also known as “sweat equity”). The value of each member’s contributions must be recorded in their capital account (the account maintained to record each member’s initial and subsequent contributions). The value of cash contributions is obvious. Property/equipment can typically be valued by reference to some kind of external metric. Sweat equity however is more difficult to value, especially as it’s prospective in nature. The value that each member views their contribution as having relative to the other members can vary significantly making early discussions critical.

4

In what state will the LLC be organized? 

States which have made a business of “housing” companies such as Delaware, Wyoming and Nevada, are not always (or even often) the best choice. If the company will be operating in a single state (e.g. a restaurant in New York), it makes no sense for the members to form the entity in Delaware as New York state requires all companies that are actively doing business in New York to register themselves with the the New York Secretary of State and to pay New York state (and City if applicable) tax. In this situation, the company will be subject to the same rules as a company formed in New York, with the added burden of having to file an annual report in Delaware and to pay annual franchise tax to that state. Are there instances where Delaware does make sense? Absolutely, but each company’s situation is different.

5.

Should the members be allowed to compete with the LLC?

Some LLC members own multiple businesses that could conceivably compete (e.g. bars in the same geographic area). Other LLC members expect that all other members will have no competing businesses. This is an important question that helps the members to understand their expectations of one another.

6.

Which of the members will be responsible for the day-to-day running of the business?

If the company is to be member-managed, will all members be involved in the day to day operations? Have the members discussed the responsibilities of each?

7.

Can members freely sell their interest?

LLCs tend to be founded by a close-knit group of people. Adding new personalities can disrupt the fine interpersonal balance that is at the heart of many LLCs. To avoid the scenario of a member’s interest being bought by an unsuitable third party, the parties can include a right of first refusal which gives the company and/or the other members the right to purchase a selling member’s membership interest.

8

What should the deadlock mechanism be?  

Deadlock occurs where the members cannot agree on a particular course of action - e.g. where unanimity is required for the company to obtain a bank loan, and one members withholds his/her consent, the company may end up in stalemate situation. In the absence of a specific deadlock mechanism, the solution to deadlock can either be costly litigation, or a petition for judicial dissolution where the members ask for judicial approval to dissolve the company.

9

How should divorce, death and disability be handled?

These can be unpleasant topics to raise at the outset of a company’s formation, however they are important ones. In the absence of an express provision to the contrary, a member’s membership interest might be awarded to a divorcing spouse whom the other members may not wish to be in business with. Likewise if no provision exists regarding inheritance, a managing member’s membership interest could pass to a relative with no knowledge or business experience, leading to severe disruption. To address these issues, mechanisms can be included in the Operating Agreement to provide for the automatic redemption (i.e. buy back) of the deceased/divorced/disabled member’s interest in the company, funded through either company funds or through (in the case of a deceased member) or a life insurance policy taken out by the company or the other members (on each of the other members) to fund the purchase of the member’s shares. This both ensures that the deceased member’s next of kin receive value for the member’s stake in the company, and provides the company with a degree of operational certainty.

10

How should retirement and early departure be handled?

What happens when an LLC member retires or decides to voluntarily leave the business? Should they retain their interest in the company even if they are no longer directly involved in the business? For certain investments - e.g. real estate that is professionally managed, this may not be an issue, but for others such as a professional practice, the members may wish to establish a mechanism to buyout the retiring member.

11

What will the valuation mechanism be?

Where there is member deadlock, or the death/divorce of a member triggers a buyout, it’s best to include a comprehensive valuation mechanism to assess the value of the departing member’s interest. The most suitable mechanism will vary from company to company, but the usual ones are a multiple of monthly/yearly revenues, or an independent valuation assessed by a third party.

12

What will the voting thresholds be?

Will major business decisions require a simple majority, a supermajority (which is some point between a simple majority and unanimity), or unanimity? Where the membership split is not equal - e.g. 90/5/5 equity would require that only the most fundamental decisions require unanimity. On the other hand, where each of the three members has a one-third interest, it seems more reasonable.

13

What actions/activities trigger dissolution?

LLCs that don’t dissolve on a pre-determined date (as stated in the formation documentation), dissolve either through a vote of the members, through a triggering mechanism (e.g. the departure of any of the members unless the remaining members agree to continue, or a vote of the members), or judicial dissolution where one or more members (or creditors) petition the court for dissolution. Understanding and determining the mechanisms is critical for all new companies.

14

Meetings

Few states require LLC member meetings, however holding regular meetings is important both to ensure important issues are discussed, and to demonstrate that the company is being treated as a separate entity from its members, which can protect against actions that seek to lift the veil of incorporation (i.e. to disregard the existence of the company in order to find the members personally liable for the actions of the company).

15

Capital Calls

Capital calls are a mechanism whereby the members can decide to require additional capital contributions from all members. This is generally to either preserve the ongoing viability of the company, or to expand/grow. Those members that do not contribute additional capital see their membership interest reduced, while those that do, see their membership interest increased. How/when capital calls are made should be clearly stated in the operating agreement.

We generally find that after discussing the above topics, the members have a better sense of their own, and their business partners’ expectations for the business, starting everyone off on the right foot.