Determining the value of the membership interest

Generally, the value of a member’s interest equals their interest’s portion of the current fair market value of the company. In other words, if the company is deemed worth $150,000 and the departing member has 25 percent of the membership, the fair market value of that membership interest is $37,500. You and the partners can decide to go to a business valuation expert — who will usually charge between $10,000 and $20,000 — to determine the fair market value of your company. Or, if your company is doing less than $3 million in annual revenue, you may want to do your best to determine your company’s value on your own.

Regardless of how you determine the value of the membership interest, you need to specify in your operating agreement that the fair market value is the price to pay for membership interest. Here is a sample provision that you can amend as needed:

If a Member resigns with the Company’s approval, the Company shall purchase the resigning Member’s Membership Interest within 90 calendar days after the effective date of resignation. The purchase price will be an amount equal to the fair market value of the resigning Member’s Membership Interest, to be calculated in good faith by the Company as of the effective date of resignation. If the resigning Member disputes the valuation reached by the Company, the value of the resigning Member’s Membership Interest shall be determined by an independent third party appraiser to be appointed by the Company and approved by the resigning Member. The resignation of a Member will not cause the termination or dissolution of the Company.

Don’t want to worry about figuring out the fair market value? Instead of using the above provision, you and your partners can all agree that if one of you leaves, the value of the membership interest shall be equal to the capital account balance. When the time comes, have your accountant figure out the specific member’s capital account balance. Here’s a sample provision you can use:

If a Member resigns with the Company’s approval, the Company shall purchase the resigning Member’s Membership Interest within 90 calendar days after the effective date of resignation. The purchase price will be an amount equal to that Member’s Capital Account balance, calculated as of the effective date of resignation. The resignation of a Member will not cause the termination or dissolution of the Company.

After you figure out the member’s interest or capital account balance and the member has relinquished their shares to the LLC, the other members can reconfigure their ownership percentages. For instance, if three members each own 33 percent of the company and one member decides to sell their shares back to the LLC, the remaining two members will each own 50 percent of the company.

You may want to consider adding a right of first refusal provision to your operating agreement. This means that before the departing member can sell their interest to the public, they must first offer some or all of it to the other members. If the company or its members do not elect to buy back the membership interest, the member can sell their membership to the general public.

All the rules regarding adding and withdrawing members can be laid out in your operating agreement or, if the requirements tend to be different for each member, individual buy-sell agreements. I will show you how to draft a buy-sell agreement later in this chapter’s “Creating individual buy-sell agreements” section.

Transferring membership

By default, membership in an LLC isn’t freely transferrable. Unless you explicitly allow for it in your operating agreement, you can’t just sell your ownership like you would a share of stock. Instead, your membership is broken into different rights, namely voting rights and economic rights. The reason for this dates back to the beginning of LLCs and the IRS requirements for allowing them to enjoy partnership taxation, but that’s not important. The key takeaway is this: Typically, when you transfer your membership to someone, that person doesn’t automatically receive all of the rights that you possess.

The default rule in most states is that when you transfer your membership interest, you transfer only the economic rights to that interest — entitling the new owner to the same profit and loss distributions as you were to receive as owner — but no voting rights. This law protects you and your partners from waking up in the morning to find that you’re now partners with someone completely different than who you started the company with. In most LLC structures, the full rights (both economic and voting) of the membership interest cannot be given to the new member without the unanimous approval of the other members, which is taken during a member vote. The vote should be documented in a formal, written resolution that all voting members must sign.

For example, say you want to gift your LLC membership to your brother. That seems fair, right? After all, it’s your membership, and you can do what you want with it. Well, not so, according to most states’ laws. Your brother will have your economic rights and profit and loss distributions but no voting rights, essentially making him a silent partner. He can enjoy the financial benefit of the membership interests (if there are any); however, he cannot be involved in any decision-making for the company.

This arrangement definitely creates some hassles, but it’s not necessarily a bad thing: These laws can form the basis of charging order protection, one of the most powerful forms of liability protection out there. I will discuss this in more detail in the next section.

Using transfer restrictions to your advantage

As I describe in Chapter 16, this “nuisance” of being unable to freely transfer membership forms the basis for a pretty hefty charging order protection strategy. In this strategy, say you own ABC Realty, LLC. One day, you’re at the grocery store, and a woman jumps in front of your car. You barely hit her, but lo and behold, you have a lawsuit on your hands. Your ABC Realty, LLC membership is considered a personal asset, so when she goes after everything you own, your company ownership is also thrown into the mix. So, what do you do? You stop worrying and let her take it.

As long as your LLC is structured as outlined in this chapter, this unfair and angry creditor is about to get much angrier. You see, according to the rules, the creditor cannot foreclose on your full membership interest — only the economic interest. Then, after the creditor seizes this economic interest of the membership shares, you and the rest of the additional members can vote to withhold distributions of profit. The creditor must still pay taxes on their membership, even though they cannot pocket any of the company’s profits. Drag this on for a few years, and I guarantee you’ll have a creditor anxious to get out of the situation and settle at a more reasonable sum. I go over this strategy in more detail in Chapter 16, but you need to know that this limitation to transferring ownership has an upside.

When drafting your operating agreement, add a provision under the Transfer and Assignment of Interests section that reinforces your charging order protection. Here’s a sample provision that you can use:

If a creditor obtains a lien or a charging order against any Member’s membership interest or in the event of a Member’s bankruptcy or other involuntary transfer of interest, this act shall constitute a material breach of this Agreement by such Member. The creditor or claimant shall only be considered an Assignee and will be limited to the rights of such. The creditor or claimant shall have no right to become a Member or have rights to management participation nor have the right to participate as a Member or Manager in any regard to the affairs of the Company. Said creditor or claimant shall only be entitled to receive the share of profit and losses, or the return of capital, to which the Member would otherwise have been entitled.

You may want to take this a step further and state that the partners have the option of purchasing the assigned membership shares at a discount:

The Members may unanimously elect to purchase all or any part of the membership shares that is subject to the charging order, bankruptcy, lien, or other involuntary transfer at a discounted price. The price shall be equal to one-half of the fair market value of such shares. Written notice of such purchase shall be provided to the creditor or claimant.

Parting on peaceful terms

Usually, a member knows when a situation isn’t right for them. Although you may still need to have a painful conversation, this is ultimately the best situation for everyone. After all, you don’t want someone involved in your company against their will. Or maybe the member just needs cash and wants to sell their membership. Whatever the reason, a peaceful exit is usually just that — peaceful. However, specifying the terms for such an exit in your operating agreement is good.

When a member leaves on their own accord, the company has two options: either buy back that member’s interest or force the parting member to try to find a buyer for it. If the company’s operating agreement prohibits the member from resigning, their interest can convert to a purely economic interest. Hopefully, the buyer is okay with being a silent partner because they wouldn’t get any voting rights!

In most cases, you want to leave the option open to the other partners. In other words, if the company has money, then the members can vote to buy back the membership interest of the departing member. If the company is cash-poor at the time, the remaining members can leave the burden on the departing member. Here’s a sample provision you can use that allows for this option:

Any Member may resign from the Company at any time. However, the Company will not be obligated to purchase the resigning Member’s Membership Interest without the unanimous approval of the other Members.

Removing a member or dealing with divorce

You know that saying: A chain is only as strong as its weakest link. In business, it’s no different. Sometimes you have to make the hard decision to eliminate a member. Other times, their membership becomes subject to their divorce proceedings, which could destroy the business in the fallout if not accounted for beforehand.

If you and the other members decide that a particular partner has no place in the day-to-day operations of this business, this can be as simple as firing them, removing them as manager (if they were one), and letting them remain as a silent owner. If you and your partners decide that letting that member retain silent ownership is the best course, you can simply place this provision under the Expulsion section of your operating agreement:

No Member may be expelled from the Company.

However, if you want to take a more hard-lined approach, you want to specify the terms under which a member can be expelled. Baking into your operating agreement the ability to kick out a member is also a good way to deal with the potential scenario of a member getting divorced. First, decide if a member can be expelled without cause, meaning you don’t have to give a specific reason. All other members can simply vote the reject off the island at their whim.

Because there are quite a few reasons why a member may become a liability for the company (aside from simply disliking a person), a more common approach is to list specific causes for the other members to expel a specific member. Here are some provisions that you can amend (simply add or remove causes) as you see fit:

• The Company may only expel a Member for cause, upon the approval of a majority of the Members.
• Any of the following will constitute “cause” for the expulsion of a Member:
  1. It is or becomes unlawful for the Company to carry on its business with the Member;
  2. The Member files a voluntary petition in bankruptcy or is adjudicated bankrupt or insolvent;
  3. The Member has engaged in misconduct that has caused or is likely to cause a materially adverse impact on the reputation of the Company or on its business or internal affairs;
  4. Commencement by the Member of a legal proceeding against the Company;
  5. The divorce or separation of a Member results in a transfer or assignment of membership interest to the Member’s spouse, ex-spouse, or dependents;
  6. The Member’s conviction of a felony or misdemeanor (excluding routine moving violations or tickets);
  7. The Member’s material breach of this Agreement.

In the operating agreement, you and your partners can state that when a member is expelled for cause, the value of the membership interest is lower. In other words, the company can buy back the membership of the expelled member at, say, 50 percent of the fair market value of the membership interest. This would be drafted as a separate provision under the Expulsion section of the operating agreement.

When it comes to hiring, firing, and retiring members who are also managers, state law is usually silent on the issue. So, you need to have provisions in your operating agreement that discuss how managers will be retained and replaced. If the LLC is manager-managed, the operating agreement should state that the members get to vote every year on whether to replace the current manager. The members should also be able to take a special vote to expel the manager at any time if need be. Managers should also be admitted in much the same way — with a vote of the members.

As for the manager withdrawing, you have to choose whether to allow it and, if you do not allow it, what penalties will be assessed for the damages incurred by their withdrawal. This should also be placed in the operating agreement. If your LLC is manager-managed, feel free to amend some of the above provisions according to what you and the other members agree on and place them in the Management section of your operating agreement.

Dealing with the death of a member

Sad as it is, death is the great equalizer in life. Young or old, rich or poor — it will happen to all of us.

Although you can decide on your own how your LLC behaves upon a member’s death, the law always protects the remaining members’ interests, especially from the passing member’s heirs. Because membership shares of LLCs are considered personal property, those shares will go through estate and probate much the same as the other assets of the deceased. The membership shares will be distributed according to their will or estate plan. Therefore, you can easily end up with a new partner.

The plus side is that, if your operating agreement is worded correctly, the beneficiary of the LLC membership interests has no real power in the company, only an economic interest. So, the beneficiary can receive only the portion of profits and losses that their membership shares entitle them to. When it comes to voting, they have no say. When it comes to managing, they must remain silent. They can only become a full partner if the other partners take a vote and agree.

Here’s a sample provision you can use:

Upon the death of a Member, the deceased Member’s legal representative, successors, or heirs (collectively “Member’s Estate”) will retain the Member’s Economic Interest subject to the terms of this Agreement but will not be entitled to participate in the management of the Company. The Member’s death will not release the Member’s Estate from any obligations or liabilities incurred before death. The death of a Member will not cause the termination or dissolution of the Company.

If you don’t like the idea of having a member’s heirs as partners, you can also add a provision to your operating agreement stating that the LLC has the right to buy back the shares within a certain time frame. Here’s a sample provision that you can edit accordingly:

The Company will have the option to purchase the deceased Member’s Membership Interest by delivering written notice to the Member’s estate within 60 calendar days after the death of the Member. The Company will then have 90 days from the date of the notice to pay the Member’s estate an amount equal to the fair market value of the deceased Member’s interest, to be calculated in good faith by the Company as of the deceased Member’s death. If the deceased Member’s estate disputes the valuation reached by the Company, the fair market value will be determined by a neutral third-party appraiser selected by the Company and approved by the deceased Member’s estate. The death of a Member will not cause the termination or dissolution of the Company.

Ensure that all actions on behalf of the company members, especially those concerning adding and withdrawing members, are clearly documented in the company minutes. Recording these changes shows a history of the company procedures and will be invaluable if any actions are contested or if the company is taken to court.

Creating individual buy-sell agreements

In many cases, the members of a company aren’t necessarily equal. They contribute different things and have varying levels of ownership. One member may run the day-to-day affairs of the business, while others just sit back and reap the rewards. Considering this, you may want different membership transfer policies for different members. In this case, you generally don’t place these provisions in the operating agreement. Instead, you give each member their own buy-sell agreement.

A buy-sell agreement outlines the rules governing how a member may voluntarily or involuntarily transfer their membership. It also explains what the company and that member (or her estate) should do if they retire, go bankrupt, become incapacitated, or pass away.

If your buy-sell agreement covers all company members, just include these provisions in your operating agreement instead. But with LLCs, you don’t have to hold everyone to the same standard. If you want, you can have individual buy-sell agreements for each member, each containing different rules and restrictions.

A buy-sell agreement must cover

• How much money a member’s shares are worth
• Who controls the member’s shares if they leave the LLC for any reason
• The reasons why someone may be admitted as a member and issued membership shares
• What happens to a member’s shares when the member departs or withdraws, for example:
  • The LLC or the other members can purchase the shares
  • The shares can be sold to the general public
• The process of transferring membership shares
• What happens if a member declares bankruptcy or gets a divorce

If you are using buy-sell agreements (rather than outlining general rules in your operating agreement), when the company issues membership shares to a new member, you must create a buy-sell agreement at the same time. Otherwise, a buy-sell agreement you create after issuing membership shares may not be retroactive. If you’ve already issued your membership shares and now want to create a buy-sell agreement, make sure that

• The buy-sell agreement is in writing and in accordance with state laws
• All members vote on the agreement and sign the written resolution
• The agreement specifically states that it covers all current LLC members

When drafting a buy-sell agreement, you can use the same provisions that cover membership transfers and would normally be found in the operating agreement. You simply adapt each provision to the specific circumstances you want to be outlined in the buy-sell agreement.

If you’re using individual buy-sell agreements and don’t have these important provisions drafted in the operating agreement, then you MUST make sure that each member has a signed buy-sell agreement on file.

Like operating agreements, buy-sell agreements can vary substantially, and what’s in them is very particular to your state’s laws on what’s allowed and what’s not. With that in mind, patching together an agreement from various fill-in-the-blank forms you find on the Internet (I know you’ve done it!) can be a dangerous proposition in this case.

Making room for new members

When the LLC or its members do not buy back the shares, you should make room for one or more new members on the team. The good news is that unless you’ve structured your LLC to specifically allow the membership interests (including their voting rights) to be freely transferable, you and your partners should have a say in how much power the incoming members are entitled to.

When the membership shares are sold, the incoming member(s) won’t have full rights in the LLC; they have only economic rights, which means they get the profit and loss distributions but have no right to vote or manage the LLC. However, the other members can vote to allow the incoming member the previously denied rights. At that point, they become a full member. When you take this vote, make sure to document it clearly in a written resolution signed by all of the members.

Also, make sure to amend your operating agreement with the new ownership percentages. The new member must also sign this amended operating agreement, agreeing to be bound by the same terms as you and your partners.

Giving old and new members their fair share

In a perfect world, membership would be transferred only on January 1 (or at the beginning of your fiscal year). Unfortunately, this is rarely the case, which presents a complication when it’s time to dole out the previous year’s allocations and distributions of profit (or loss if you didn’t have such a great year).

When a new member joins your LLC, you should prorate that year’s distributions based on how long they have been a member during that current fiscal year. For instance, say a new member, owning 10 percent of the LLC, is admitted to the LLC on July 1. Should they get their full 10 percent of the profits at the end of that year? Of course not!

In this case, if the total profits distributed are $100,000, the new member should receive only 50 percent (for the half year they were a member) of the 10 percent (their ownership share) for a grand total of $5,000. After that distribution, the remaining $95,000 can be distributed according to the other members’ percentages. Your accountant can assist you in your exact calculations; this example is just a quick and easy (yet oversimplified) overview. When figuring out the exact amounts, you must consider other things, such as each member’s capital account balance. More on capital account balances in Chapter 13.

Whether you bring on a new member, or the company buys back the membership interest, the reverse is true for the departing member. If they relinquish their interest on July 1, there is no reason for you to give them a full distribution at the end of the year. It can be prorated for when they were a company member.

It would be smart to define these terms of prorated distributions in your operating agreement (or buy-sell agreements) now rather than later, especially because economic interests are usually the “freely transferable” part. Can you imagine the outcome if a member were to buy in on December 20, take a huge chunk of the distributions for that year, then sell out on January 2? Trust me, it’s happened, and the only way to prevent that situation is to make sure your operating agreement or buy-sell agreement clearly states that distributions are calculated according to the number of days of the year the member has been admitted to the LLC.

Signing and Ratifying

With an LLC, all your managers and members should sign the operating agreement. Some of the worst client problems I have seen arose because not every member had signed the operating agreement, resulting in thousands of dollars of legal fees and lost time from disputes.

To protect against this, not only should each member (and manager, if manager-managed) sign off on the operating agreement, but they should also sign off on their capital contributions, membership interests, and distributive shares listed in the agreement. If the company has a lot of members, you can include a separate signature page.

You should also make sure that you hold a meeting of the members (and managers, if you like) and take a vote to approve the completed operating agreement. You should draft meeting minutes to further document that all the members got together and approved the document. This way, if the document is ever contested in court, you can prove that the contesting member was there when the document was up for a vote and could have disputed the document at the time. This is why it’s a good idea to have all the members approve the operating agreement instead of a simple majority. (For more information on how to document company decisions and draft resolutions, flip to Chapter 12.)

Sharing the copies and storing the original

Each member and manager who signed the operating agreement should have an original copy, including all signatures, either in their physical possession or accessible by them in your company’s digital records kit if you’ve gone the digital route. This ensures that everyone is on the same page and is familiar with company policies they’ve agreed to abide by.

Amending the operating agreement

As companies grow and change, so should their infrastructure. If you are in this for the long term, you’ll probably reach a point when the operating agreement needs to be amended. How you amend your operating agreement should be specified in the most recent version of your LLC’s operating agreement. Otherwise, it’s largely determined by the state’s laws where your company is domiciled in. If your current operating agreement states that it must be amended by unanimous consent, then all members will have to approve the amendment. If it states that a unanimous vote by the managers can amend the operating agreement, then all managers need to sign, approving the amendment.

This provision should be placed in the Amendments section of your operating agreement, which I show you how to do in Chapter 8.

When amending your operating agreement, hold a meeting of the members (see Chapter 12), present the amendment for a vote, and draft a resolution stating that all (or a majority) of the members agree to amend the operating agreement. Again, you want to abide by whatever is stated in your current version of the operating agreement.

Having this proof that all members agreed on changing the operating agreement is vital because if a member ever takes you to court over something in the operating agreement, you can prove that they voted and signed off on the amendment. After the vote, make sure all members have copies of the signed amendment and all resolutions.

Unlike when you amend your articles of organization, you don’t need to file the amendments to your operating agreement with the state or local jurisdictions because your operating agreement isn’t a public record. Your operating agreement is a private contract between the LLC’s members (and managers), meaning your amendment is valid as soon as it has been voted on.