All things must come to an end, which includes membership in a Limited Liability Company (LLC). Whether voluntarily, acrimoniously, or due to life changes, including death, a member of an LLC is not necessarily a member forever. However, ownership in an LLC continues in one form or another and must eventually (and more likely sooner than later) be subject to accounting.
While many circumstances can give rise to the loss of a member’s equity interest in an LLC, the operating agreement for the LLC should provide for mechanisms that govern or require a member’s exit from an LLC, the rights of remaining members in such an event, and/or the termination of any member’s interest in the LLC. In most cases, such mechanisms are detailed in the buyout and trigger provisions in the LLC’s operating agreement. These provisions, commonly called a “put-option,” a “call option,” or a “buy-sell agreement,” are essential for maintaining the stability and functionality of the LLC, addressing potential conflicts among members, and ensuring the smoothest transition of a member’s ownership interest in an LLC, especially when not voluntary.
Voluntary Buyouts
When a member voluntarily decides for whatever reason to cash in their LLC “chips,” a well-crafted buyout provision (or put or call provisions) will set forth how and to whom they can sell or transfer their interest and a method for establishing its value (see below). More often than not, these provisions will give existing members the right of first refusal to purchase the departing member’s interest before they can offer it to an external buyer, a mandatory obligation of the selling member to offer shares to the existing LLC members under certain events, and/or a less-tailored buy-sell provision. As with all LLCs, the members can establish any number of governance provisions without running afoul of the applicable state LLC statute. For example, if the transfer provision at issue allows for the transfer of a member’s interest to a new member, it may also establish limitations and criteria as to who can purchase the interest. There are multiple variants of this theme, and topping the list is the formula for calculating a buy-out or option price.
Involuntary Buyouts
Certain events that happen to individual LLC members can threaten the stability or viability of the entire LLC and the other members’ interests. In most circumstances, the legal and contractual governance of an LLC will prevent one member’s equity interests from being transferred to a third party without severe limitations on that recipient’s rights. For example, many operating agreements and/or LLC acts limit a transfer of an LLC equity or “membership” interest such that the recipient is but an “economic interest holder” – one with informational and distributional rights, but without power to affect the governance of the LLC. In the case of a buyout provision, parties should anticipate and identify these triggering events.
Typical triggering events included in a buy-sell agreement include:
- A Member’s Death or Disability: the operating agreement might specify that a deceased, disabled, or incapacitated member’s interest should be offered to the surviving members or the LLC itself before any other parties, on dictated terms.
- Bankruptcy or Insolvency: If a member declares bankruptcy or is otherwise insolvent, the operating agreement may include provisions for the automatic buyout of their interest to protect it from the member’s creditors and prevent potential financial instability within the LLC. Other issues exist as to the protection of a member’s interest from a creditor or debtor, but that is beyond the scope of this article.
- Misconduct or Violation of Operating Agreement: If a member violates material terms of the operating agreement, such as engaging in activities that harm the company or competing with it directly, the agreement may allow for the forced buyout of such member’s interest.
- Divorce or Family Transfers: In the event of a member’s divorce, the operating agreement might address the potential transfer of a member’s interest to a spouse or ex-spouse and provide mechanisms for managing such situations. It may also specify conditions for the transfer of interests to family members to ensure that the new member aligns with the company’s objectives and gives flexibility to the transferring member.
Valuation Methods
A crucial aspect of put, call, and buyout provisions is the determination of the value of the subject member’s interest. Various valuation methods can be set forth in an operating agreement to ensure fairness and objectivity in the buyout or put/call process. These methods include:
- Book Value: The simplest method of establishing a membership interest’s value is to determine the net asset value of the company, divide it by the total number of units, and then multiply it by the departing member’s units. While straightforward and based on readily available financial information, book value is often the least favored valuation mechanism to accurately reflect the actual market value of the company.
- Capitalization of Earnings: This method values the business by considering its future earnings potential. Calculations can include multiple(s) of earnings, discount percentages and/or discount amounts (e.g., lack of operating and/or voting interests). Such provisions can be tricky, as they require making imprecise and speculative forecasts and assumptions about future performance.
- Independent Appraisal: An independent appraiser or appraisers can assess an LLC’s operating value based on various factors such as financial performance, industry trends, and market conditions. The procedure to do so should not be ignored and left to hindsight.
Funding the Buyout
Any LLC operating agreement should in the case of such provisions define the payment terms in the event of a triggering event, whether it is a lump-sum payment, installment payments, or a combination of both. In cases where members cannot afford an immediate buyout, the agreement may outline financing options or the use of company profits to fund the purchase.
As a business evolves, and the lives, circumstances, and priorities of LLC members do as well, a well-crafted operating agreement is essential to smooth sailing. This includes giving thought to and detailing well-crafted buyout provisions, as these can be the key to maintaining business continuity and reducing a potential source of disruptive and costly conflicts – that can arise in any number of circumstances all too well known to LLC members, officers, and managers who have endured these types of toils.
If you have questions or concerns about buyout or trigger provisions in your LLC’s operating agreement or would like assistance preparing an operating agreement, please contact me at 312-840-7004 or fmendelsohn@burkelaw.com.
