Aside from choosing what entity to form your business as, one of the most important considerations in the early stages of forming a company is the exit strategy. Ironic as it may sound, deciding how to get out of the business in the beginning will save you and your business partners time and money down the road. As we’ve discussed throughout our series on LLC Operating Agreements, there is a lot of flexibility when deciding what provisions to include in your operating agreement. It’s no different when deciding on exit strategies, restrictions, and procedures for your LLC. Some LLC operating agreements are silent on this point, while others include extensive restrictions and procedures for getting out of the company. Today’s post will detail some of the more common exit provisions in an LLC operating agreement.
Buy Sell Provisions for Departing LLC Members
Buy sell provisions detail what will happen when an LLC member decides to leave the company, dies, or is otherwise unable to continue to participate as a member of the LLC. One of the most common buy sell arrangements is the “right of first refusal.” This provision allows a member to sell his interest in the LLC to an outsider as long as the interest is first offered to the existing members of the LLC (and such members decline).
Here are some of the common ways members depart from an LLC and some considerations for each:
Resignation of a Member
Members of an LLC should specifically address the treatment of a member who voluntarily departs. An operating agreement may require a member to continue work for the company for a period of time before they can receive any compensation for resigning. It’s also important to consider including noncompete clauses in the operating agreement in order to protect against a departing member directly competing with the LLC. It’s also extremely important to include a process for valuing the departing member’s interest in the LLC. Deciding on a valuation method upfront will avoid significant hassles later on. In order to avoid any hassle, it’s smart to include provisions that detail how a member can resign from the LLC and the process for the financial payout for the resigning member’s interest.
Death or Disability of a Member
The members of an LLC may include in the operating agreement the dissociation of a member by death or disability. The agreement often provides that this event triggers a buy-out of that member’s interest according to an agreed upon valuation method and payout plan. By planning for such an event, you can provide the timely resolution of a dissociated member’s interest.
Expulsion of a Member
Another provision may force a buyout of the member’s interest in the case of a serious breach of that member’s obligations to the company. In the case of a professional limited liability company (or PLLC), if any member has lost his license to practice the profession, the LLC may be required to buy out that member’s interest. Depending on the business purpose, the members should consider providing for automatic expulsion upon the happening of certain events that will inevitably harm the company. Members may also choose to allow for expulsion if a majority (or certain percentage) of the members vote to expel another member. In the case of expulsion, the agreement should provide terms for the financial payout to the expelled member.
Transfers of LLC Interests
Another common exit strategy is to simply sell, or transfer, your interest in an LLC to another person. It’s important to include details in the LLC operating agreement that account for this type of transaction. Transferring or assigning a member’s interest can pose a number of problems for both the selling member and the remaining members of the LLC.
For the selling member, it’s important to transfer as many of the management and financial rights as possible in order to collect the greatest profit. However, this creates a struggle because the remaining members of the LLC seek to restrict management rights of the “new” member as much as possible. Most LLC statutes address this issue. For example, in Washington, an assignee has no right to participate in management of the LLC unless all members approve or the LLC operating agreement provides for such participation. Most states follow this or a substantially similar approach. Due to the potential for conflicts, it’s important to include provisions in the LLC operating agreement that outline the procedure for transferring or assigning LLC interests, as well as the rights and obligations of the assignee.
Dissolution of the LLC
An LLC may be dissolved for a number of reasons: the LLC may have been formed to exist for a specified duration; the last remaining member is seeking to withdraw; all members consent to dissolve the LLC; or the LLC may be judicially dissolved by the court or administratively dissolved by the secretary of the state. The LLC operating agreement should include clear details about the process for dissolution, including how the LLC will wind up its affairs.
Hope for the Best, but Prepare for the Worst
Nobody likes to think of the end, and people are even more reluctant to think of how good situations can become bad very quickly. Failing to do so can lead to a number of unnecessary complications. When forming an LLC, it’s vital to hope for the best, but to also prepare for the worst. When things get tough (and they always do), it will save your company time and money if there are a set of procedures already in place.
It’s important to consider exit strategies when drafting an LLC operating agreement. Members should be prepared to consider and discuss the endgame. Deciding on the procedures for exiting the LLC during the early stages of formation is undoubtedly the best way to ensure that, if and when the end arrives, it does not overwhelm and frustrate the entire operation of the LLC.
Value For You and the Company
Exiting a company can be messy if the LLC isn’t properly governed and the remaining members aren’t on board with the decision. And this applies not only in situations where a member is “forced” to leave. In fact, there are a number of reasons why exiting the LLC may be in the best interest of both the departing member and the LLC (and its remaining members). For example, it may be time for a member to retire, and the LLC may benefit from bringing in new blood to rejuvenate the company. A member may want to accept a government or other appointment that requires leaving the LLC. Or it may simply be a good time for particular member to liquidate and reinvest. Nevertheless, setting parameters for what it will take to pursue these goals from the beginning will promote clarity and transparency for you and your business partners.