Originally published on July 17, 2018
Unfortunately, business relationships don’t always work out as expected, and you may need to remove your partners from their equity ownership / member position in your LLC. Hopefully this process is clearly defined in your Operating Agreement. If not, it can quickly become a daunting challenge to remove an uncooperative member.
Some basic terminology about Limited Liability Companies (“LLCs”):
Operating Agreement: This is the document/contract that governs the entire company. It lists who owns what interest, the voting procedures, the process upon dissolution of the company, the removal of a member, etc. It’s similar to a corporation’s by-laws or a partnership agreement. Most states do not require this document, but it is highly recommended to promote smooth operation.
Member: This is a person who owns an interest in the LLC — they can be either be a managing or non-managing member.
Membership: That’s the right to participate in the Management of the LLC, this is defined more clearly in your own LLC’s operating agreement in terms of the scope of power each member has.
Managing Member: This is a member who typically has voting rights and manages the day-to-day operations of the company.
Transferrable Interests: This is the right to receive distributions of the LLC’s assets, also defined in the Operating Agreement.
Registered Agent: This is a person designated by the LLC to receive legal papers. Typically, their address gets filed with the State.
Articles of Organization: This is the document filed with the Secretary of State to start the Company. It must include the names of the Members, the address of the Company, the Registered Agent’s name and address, and some states require a broad explanation of the nature of the business.
Ownership Percentages: LLC ownership can be expressed in two ways: (1) by percentage; or (2) by membership units, which are like stock shares. In either case, the ownership interest comes with the right to vote and share in profits.
Distribution of Ownership Percentages: An LLC can distribute these ownership interests as it pleases, without regard to how much money or property a member contributes. For example, if Joe contributes $5,000 and Jack contributes no money, but does all the work, they can still decide to split the membership interest 50/50 or any way they choose.
Voting Power: Whether a membership interest gets voting power depends on the Operating Agreement, and can be done in any way the owners see fit.
When are LLC interests Securities?
It depends; a member (or their attorney) needs to look at the Federal laws through the lens of the 1933 Act definition and the Howey test. SeeS.E.C. v. W.J. Howey Co., 328 U.S. 293, 299 (1946) (“An investment contract for purposes of the Securities Act means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party . . .”). Each state may have slight variations on their classification of membership interests as well, so that’s important to check, too.
This question is important to answer before selling ownership interests; if the interest is a security, it needs to be either registered as such, or to qualify for an exemption from registration. One common exemption is Regulation D, which poses some limits where the Members need to be Accredited Investors, and Form D must be submitted to the SEC.
If there are no silent partners, it’s less likely that the LLC is a Security, because everyone is contributing to the project. Courts take a fact-intensive look at the LLC and the contribution of each member to decide if, in fact, the ownership interest is profits being derived from the entrepreneurial or management efforts of others. Some factors that go into this calculation include:
- How much control does each member have according to the Operating Agreement?
- Were membership interests sold to a large number of investors or the general public?
- Do the members have sufficient business experience and knowledge to exercise their management rights?
- Are the members dependent on a promoter or manager because of some unique expertise that individual has?
What to do when you want to remove a member?
The procedures for removing a member from the LLC should be clearly articulated in the Operating Agreement. If they are not, the members wanting the change need to have a meeting, agree on a buy-out price, and make the member they want to disassociate from an offer. That member can either accept the offer, or take them to Court. The Judge would then review the facts and make a sound determination as to whether the buyout price was fair. Some Judges may require the entire LLC be dissolved, and everyone be paid their pro-rata share. The remaining members can then start a new company on their own.
Do you have to buy them out?
The typical rule is that the withdrawing member is entitled to their proportionate share of the profits, losses, and Net Distributable Cash of the Company from the beginning of the Company accounting year. See68 Del. Laws, c. 434, § 1; 70 Del. Laws, c. 186, § 1.
The only time you can avoid paying that member their pro rata share is if the LLC is in a position where it owes money to creditors in an amount that exceeds the fair value of the assets. Should a distribution be made in violation of this creditor provision, and the person receiving the distribution knew, they will be required to return the sum of the distribution. See 69 Del. Laws, c. 260, § 29; 72 Del. Laws, c. 389, § 23.;
This document is typically executed through an LLC buyout agreement, where you have the exiting member and the remaining members all sign a binding contract outlining the price and any other specifics of the buyout.
LLC’s are the most flexible company structure we have, but it’s very important to lay everything out clearly from the beginning in the Operating Agreement so there’s no question regarding what to do when personalities conflict down the road.