I get clients and a lot of questions about Limited Liability Companies (LLCs) and Operating Agreements. It seems like it’d be a good a idea to address some of these questions in bulk rather than repeating the same ideas over and over. So, here we go.
There’s a lot of discussion and anecdotal (in this case, “anecdotal” from the Latin meaning “from an otherwise trustworthy source which, in this case, has no actual knowledge and is merely repeating something they heard from someone else”) evidence that “LLCs are the same as incorporating only cheaper!” As you may be able to tell from my snarky tone (it’s really hard to communicate sarcasm in the written word), I don’t subscribe to this piece of information.
Here’s the thing, in most situations, this is the case, but to figure out if it’s really what works for you and your business, you really should talk to a lawyer, not just read some blog posts and Wikipedia. As a result of misinformation, I talk to a lot of clients who file their own LLC paperwork with their state and then contact me about their Operating Agreements* with questions on how they should be written.
Generally, these conversations start with, “I’ve already written the Operating Agreement, I just need you to look it over and make sure it’s ok.” Which means, in many cases, “I’ve found a template on-line and filled in the blanks and I want you to tell me ‘it’s fine.’” At that point, I ask some questions about their business and read the “draft” and have to convince them that what they’ve got has almost no relation to 1) what they need and 2) the legal requirements in North Carolina. So, I hope to, with this article, get people to realize the complexities involved, or at least think about some issues before they call me… or another lawyer, but hopefully me.
I get this issue very very often. I see a lot of Operating Agreements that say something like “Jim Jones will own 10% of the LLC and Sam Smith will own 90% of the LLC.” Well, this doesn’t actually work very well with LLCs. To understand why, you have to understand a little of the history of the LLC.
The corporation has been around for a very very long time. Some of the original organizations that we think of as corporations required a special charter from the Sovereign (think Lloyds of London). The issue that comes down with that history is that corporations are controlled by shares of stock, that is fractional pieces of ownership. You effectively controlled the company proportional to the number of shares of the company, effectively how much of the company you owned. For example, if the corporation has 100 shares of stock, and you hold 30 shares, you have a 30% stake in ownership of the company and 30 votes of a possible 100 votes possible in making decisions for the corporation.
But, see, the thing is that LLCs didn’t come from the auspices of corporations. LLCs are much more akin to Partnerships than to corporations. Think about a partnership. If there are 100 partners in the company, if you’re a partner you can only “own” one vote of the possible 100 votes in making decisions. Or, seen another way, if you’re in a partnership with one other person, you can’t have 60% of the partnership – you can only have 50% of the ownership, since there are only two of you. LLCs are a lot like that. LLCs were designed and envisioned for so-called “closely held companies,” meaning that only a few people “own” the LLC. Because of that, LLC Members (the LLC equivalent of shareholders) are all treated equally. You only “own” the fraction of the LLC that is one (i.e. you) divided by the total number of Members. So, if there are two of you, you “own” 50%. If there are four Members, you only “own” 25%.
Now, because the law of Partnerships allow for having different kinds of partners (Senior Partners, Junior Partners, Equity Partners, non-Equity Partners, etc.), you might expect that LLCs allow different kinds of Members. And, in fact, that is the case. So, generally speaking, if you want to have one Member have more control, or more entitlements, than other Members, you have to have at least two different kinds of Members (called Member Classes). And, to have different classes of Members, you need to specify what the rights are of each class of Members. All the sudden, you can’t rely on just percentage ownership (because there aren’t shares or things being split up for ownership), you have to spell out who has what and why. And, the Operating Agreement becomes more complex and might need a lawyer and not a template to sort out.
Something that I often see is an Operating Agreement that says something like “Members cannot withdraw from the LLC.” Well, that’s not going to work! What happens if you die? Well, you’ve certainly “withdrawn” from the LLC then.
The point is that the law says that you can’t have ownership of something that’s “inalienable” (meaning that it can’t be sold or separated from the person). A good example is found in Real Estate: you can’t say in a deed “the old homeplace can never be sold to anyone ever.” Any Court in the US would summarily ignore those words and determine that the property has been sold to whoever has paid for it. Same thing in LLCs. You have to have a way for someone to leave the LLC.
Which leads to the other (wrong) example that I see a lot; “any Member withdrawing from the LLC must sell their interest to the other Members.” While, in theory, that sounds good, imagine if someone had invested $100,000 in the company and then wants to leave. But, now, because he “must sell” to the other Members, what happens when the other Members say, “cool, we’ll pay you $3.48 for your interest because you can’t sell to anyone but us.” That’s not very equitable (i.e. fair), and the Court really likes things that are equitable. You have to have a provision that allows for someone withdraw from the LLC and for them to get a fair price for their interest in the LLC.
There’s no “wrong example” for this one because I see it so rarely, but it is – if not critical - really really important. Here’s the thing, imagine that entering an LLC is a lot like getting married. You better trust your fellow Members and it’s going to be really painful to get out if you’re not very careful. So, just like married life, you will have arguments and disagreements about various aspects of the marriage/business. You need to have a way to work through disputes between the members that doesn’t involve withdrawal from the LLC.
Withdrawal is your ultimate option if there’s a disagreement, but you probably don’t want to withdraw from a successful business just because you think that the LLC “must pay the members” rather than the LLC “may, at the discretion of the Managers, pay the members.” I recommend to clients that there should be an administrative procedure included in the Operating Agreement to deal with disputes among the members; mediation is a good first option.
Because LLCs were envisioned like partnerships, the “default setting” is that all Members have equal rights to manage the business. That might not always be the case. In North Carolina, a required selection during the paperwork/registration process is whether you will be a Member Managed LLC or a Manager Managed LLC. Think of it this way: for a Member Managed LLC, all Members are managers of the business and have equal rights. For a Manager Managed LLC, all Managers are Members, but not all Members are Managers. This is an important distinction for people who want to have other owners or investors, but who want to retain “control” of the business. It’s something to think about.
Ok, but what if I don’t
Ok, if there’s not an Operating Agreement, or if some of these things aren’t included, there is another option (seen of as more of a penalty by attorneys like me): Dissolution. That is, if you can’t sort it out, the Members sue each other and/or the company and a Judge orders that the LLC is dissolved.
This can get really really sticky or nasty having to sell off assets or parts of the business (at this point, only the lawyers win). All because you couldn’t see eye-to-eye on an issue or because there’s no way for the Member to leave the LLC or whatever. Dissolution should be a last resort, “nuclear option” for your business. But, without a well drafted Operating Agreement, that “nuclear option” might become the only option much more quickly than you might imagine.
*For WHY you need an Operating Agreement for your LLC, see "Why Your LLC Needs an Operating Aggreement."