LLC Operating Agreements: Transferring Member Interests and Adding New Members
As is the case with just about every provision in an operating agreement, the rules are flexible in regards to transferring member interests and admitting new members. This latest post in our series on LLC operating agreements details the default rules and common types of provisions related to transferring member interests, rights of first refusal, and admission of a new member.
Transferring LLC Ownership Interests
Most LLC statutes distinguish between membership interests and member rights. The most important difference between the two is that the member’s transferable interest usually (but not always) includes only the member’s share in profits and losses and the right to participate in distributions (i.e. financial interests), and not the right to participate in management and control. Generally, a member’s financial interest in an LLC is freely assignable, as long as there aren’t any restrictions in an operating agreement.
In Washington, the individual or entity that is assigned a member’s interest (the “assignee”) is not entitled to participate in management of the LLC unless the assignee is admitted as a member by unanimous consent of the members or through another process detailed in the operating agreement. Once a member transfers his or her entire ownership interest in an LLC the member is no longer a member of the LLC and relinquishes all power to exercise rights or powers of a member. The assignee will be not liable as a member of the LLC strictly because of the transfer until the assignee actually becomes a member (if ever). Until admitted as a member, the assignee will only have the financial rights of the transferring member—that is, the rights to distributions, and an allocation of profits or losses.
Keep in mind, Washington’s LLC statutes allow for operating agreements to create their own rules for transferring membership interests. Restrictions on a member’s right to assign financial rights can be enforceable. Members must exercise any veto power they have under the operating agreement consistently with their fiduciary duties to the other members. That is, if exercising a veto power constitutes a breach of the member’s fiduciary duties, that member may be liable for the damages that result from the breach.
In addition to voting and management rights, LLC statutes generally deny assignees rights to information and to compel dissolution of the LLC. Assignee rights should be clearly provided for and spelled out in the operating agreement to avoid any unnecessary confusion or disputes.
Right of First Refusal
The right of first refusal generally provides that if a member receives an offer from a third-party to purchase any portion of his or her membership interest, the member must first offer the interest to the company (or remaining members) on identical terms and conditions. Generally, the company (or remaining members) will have a set period of time to determine whether or not to exercise the right of first refusal. If the time lapses and the right isn’t exercised, then the third-party purchase is permitted.
In addition, operating agreements may include a “put” provision. This “put” guarantees that a severance of ownership will occur if there are irreconcilable disputes within the LLC. This is essentially a fallback provision when a member is struggling to find a willing buyer but wishes to either sell his or her interest to the remaining members or purchase all the remaining members’ interests. This provision can be helpful in situations where the members can’t reach an agreement about future ownership.
Admitting a New Member
The default rule in Washington allows a new member to be admitted only by unanimous consent of the current members. However, operating agreements generally include procedures for transferring member interests and adding new members. There are pros and cons to having flexible or restrictive provisions related to adding new members. Generally, having a clear procedure for allowing existing members to have a say in the decision to add a new member is important for protecting members from having to manage a company with an unfamiliar new member.
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.