Thursday, April 17, 2008

Restrictive Covenants Among LLC Members

You've heard of buy-sell agreements among shareholders of closely held corporations. In the case of LLCs, the operating agreement is typically the place one finds restrictions upon transfer of LLC member interests. But why have them? A small business is much like a marriage. And one carefully chooses a spouse. If a member of your LLC is allowed to sell out to anyone of the member's choosing making the buyer of a member of your ownership group, that's a problem for the remaining members. They may be stuck to continue the business with a stranger or, worse, a disruptive individual they never would have freely chose to hook up with. This problem is magnified for LLCs that are managed collectively by the managers as opposed to having named managers who control the operation of the LLC. Any new member automatically becomes a member of the management team.

When a group of entrepreneurs trust each other implicitly at the start of a new business venture, they may think restrictive covenants among the members are unnecessary as one of their fellow members is not going to screw the LLC over by selling out. But consider the following: divorce, death, and bankruptcy. Forces beyond the control of a member may force him or her to sell. Best to plan for these eventualities on the front end so that the LLC may continue in business with the least disruption as possible should one of these events befall a member.

Another difference between corporate shareholder buy-sells and LLC restrictive covenants found in LLC operating agreements. For tax reasons, the LLC is typically the buyer of the LLC units of the departing member. Link. In shareholder buy-sell agreements, the shareholders typically purchase the stock of the departing shareholder individually.

Middle ground option. You the LLC members wish to prevent any individual LLC member from transferring his or her membership in the LLC outside of the current ownership group but you are reluctant to bind the LLC to mandatory purchase of an LLC interest upon the withdrawal, death, financial insolvency of a member. It's a legitimate concern. For an LLC whose business is thinly capitalized, the extra burden of buying out a departing member may well force the LLC into liquidation. Is there another option? Yes, forbid withdrawal or other transfer of member LLC interests. What happens upon the insolvency or death of the member? In these cases, the creditor or heirs of deceased member (as the case may be) only take the right to distributions held by the member but may not vote the LLC membership interest or otherwise exercise any rights of members. Here is a sample LLC operating agreement with restrictive covenants (see article VII). See also Online LLC Operating Agreement Form.

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