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 can save you and your business partners time and money down the road. As we’ve discussed throughout our series on LLC Operating Agreements, there’s tons 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 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 or her interest in the LLC to an outsider as long as the interest is first offered to the existing members of the LLC.
Here are some of the common ways members depart from an LLC and some considerations for each:
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 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 can avoid potentially 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
Death or disability of a member is often treated as a withdrawal. The agreement can provide 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 deceased or disabled 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, 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. In the case of expulsion, the operating 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, a member’s interest in an LLC to another person or entity. It’s important to include details in the LLC operating agreement that account for this type of transaction. Transferring 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 may seek to restrict management rights of the “new” member as much as possible, especially if it is a stranger or hostile owner coming on board. Most LLC statutes address this issue. For example, in Washington, a transferee has no right to participate in management or obtain access to information concerning the transactions of the LLC unless all members approve or the LLC operating agreement provides for such participation. 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 transferee.
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 period of time; the last remaining member is withdrawing and no new member is going to operate the business; 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, i.e. settle its debts, sell its assets, and distribute any proceeds to the members.
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 his or her interest. 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.
If you have any questions about forming a LLC or drafting an operating agreement for your LLC, please don’t hesitate to contact us today.