By Tricia Dunlap Esq.
~4 minute read
Part 3 – LLC Education Series:
The Perilous Position of LLC Minority Members
Limited liability companies are highly popular, very flexible business entities. They are cheaply and easily formed which unfortunately creates the illusion that lawyers aren’t necessary. Au contraire. The truth is that LLC’s can be a nasty trap for the “unlawyered”.
This post is # 3 in our LLC Education Series:
- What Exactly IS a LLC, Anyway?
- Operating Agreements – Essential to Your Success
- The Perilous Position of Minority Members
- Hotel California: You Can Checkout, But You Can Never Leave
- Fiduciary Duties: The Responsibilities You Never Knew You Had
A lawyer’s most important job isn’t producing the operating agreement (OA) that will govern your LLC. A lawyer’s job is helping you decide the terms that should be included in the document. A computer can produce a document! But only a knowledgeable lawyer can counsel you on its terms. Counseling is the lawyering that matters. If you are or will be a minority member of an LLC (less than 50.1% ownership) then, without a good lawyer’s counsel, you could be in an especially perilous situation.
I see it all the time. New clients arrive at Dunlap Law because the majority member of the LLC they have a minority stake in is monkeying around with the business. They can’t get a clear answer. They can’t get corporate or financial records. Maybe new members have joined the LLC and their stake has been diluted – reducing its value. Maybe their estranged spouse is selling LLC assets, jockeying for advantage in the pending divorce.
What can they do about it?
That depends on the terms in the OA and the Virginia Limited Liability Company Act.
11 Tips Before Becoming an LLC Minority Member
1. Future Dilution
If any future event occurs that actually or would have the effect of diluting the value of Purchaser’s equity in the company as of the Closing date, then will the equity dilution be shared evenly across all of the company’s members?
2. Voting Rights
Will LLC voting rights track ownership percentage 1:1? Or will each member have one vote regardless of their ownership percentage? Voting rights can be negotiated.
3. Management of the LLC
LLC’s can be either member-managed or manager-managed. In a member-managed LLC, every member can represent the LLC to third parties and legally bind the LLC to contracts. In a manager-managed LLC, only the designated manager can represent the LLC to third-parties and sign contracts. A member-managed LLC could be extremely dangerous to the LLC itself and the LLC members overall because one member could act out of alignment with the rest and create havoc. There are also risks to a manager-managed LLC if the manager’s powers are broad and it is impossible or very difficult to remove an incompetent or malicious manager. Yes, that happens.
Membership in an LLC will have consequences for your taxes. If the LLC is profitable, you will have to pay taxes on your share of the profit. Will the LLC guarantee you a distribution to cover the tax bill (so long as it can do so without compromising its ability to operate)? If the LLC is not profitable, then you’ll have a loss to report to the IRS. If the LLC is slow in filing its tax return, then you will also either be delayed or you’ll have to amend a return you already filed after you get the K-1 form from the LLC.
5. Super-majority Vote for Major Decisions
LLC minority members almost never have a say in day-to-day operating decisions but you should have a vote over “major decisions.” For a “major decision” to be approved, a supermajority (66% or 75%) should have to vote in favor. Major decisions include issues such as:
- Selling, purchasing, leasing any real estate.
- Selling, purchasing, leasing any personal property (e.g. a vehicle) exceeding an agreed-upon value.
- Borrowing money under the LLC’s name.
- Amending the Operating Agreement.
6. Unanimous Consent for Fundamental Decisions
To approve a “fundamental decision”, unanimous consent of all membership interests should be required. Fundamental decisions typically include:
- Selling all or substantially all of the Company’s assets.
- Expelling a member.
- Altering any member’s voting rights.
- Altering distribution rights.
7. Buy-out Rights
Will you have a right to be bought out by other members at fair market value if you decide to quit the LLC? Will you be allowed to leave the LLC? Yes, this can be a problem. See post # 4 in our LLC Education Series.
8. Fiduciary Duties and Non-Competition
Will members be prohibited from competing with the LLC? Will members owe fiduciary duties to one another or solely to the LLC? For more on fiduciary duties, see # 5 in the LLC Education Series.
9. Indemnification and Advancement of Costs
Will the LLC cover members’ or a manager’s costs from defending a claim or lawsuit that arises from their role as a member or manager? If so, will those costs be paid in advance or after the fact?
10. Records Inspection Rights
Will members’ rights to LLC records mirror the rights in the Act or will they be more limited? Will you have to pay for the LLC’s cost of copying or providing records?
11. Capital Calls
If the LLC is losing money and issues a “capital call” to members – demanding that members contribute money to the LLC – will you be required to pay? If you don’t pay, some of the consequences could include: (i) you lose your right to vote on LLC matters; (ii) lose your right to a distribution from the LLC; or (iii) have your interest diluted.
Next up, LLC Blog Series #4: Hotel California: You Can Checkout, But You Can Never Leave
Contact Dunlap Law
This list might have been exhausting to read but it is not exhaustive – there’s even more to consider. No one should become an LLC minority member without legal counsel, careful thought, and skillful negotiation of the membership terms. At Dunlap Law, we have extensive experience helping clients navigate these decisions. Give us a call and we’ll help you too.
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