Limited liability companies have been in common use in North Carolina for many years. The adoption of our original statute, its amendments, and the 2014 revision (LLC Act) reflected a process of acceptance that has eventually encompassed the entire United States. While the LLC Act contains default provisions and some protections for all members, it also grants the members significant flexibility to use the Articles of Organization and Operating Agreement to modify the terms of their relationship. This has led to the creation of forms that in most instances advance the traditional “majority rules” approach, making the protection of the rights of members owning (directly or indirectly) less than a controlling interest (minority member) a challenge. Although the beginning of the ownership relationship is generally infused with enthusiasm and trust, it is often the point of most leverage for the minority member. The negotiation of the company’s organizational documents is a good time to set some parameters on the authority of the controlling members and establish protections from abuse of minority members. While many of these provisions may be placed in an entity’s Articles of Organization, the public nature of that document and the difficulty in amending it make the Operating Agreement the more likely location. Set forth below are some areas to be considered in the negotiation and development of these initial limited liability company documents.
A limited liability company can be managed by its members or elected/designated managers. However set up, those managing the company will generally control its day-to-day operations, as well as make most of the impactful decisions. The LLC Act provides that the managers must operate the company and conduct its business in accordance with its Operating Agreement. It also imposes certain default standards of good faith, due care, and acting in the best interest of the company on the managers’ performance. Since these standards can be and are often modified or eliminated, placing some controls on the selection of the managers and/or the scope of the managers’ decision making will be important to the minority member. It is not unusual in small companies to have each member designate a manager. However, even though a minority member (or his/her designee) acts as a manager, including other protections such as high quorum and vote requirements, and even veto power over certain decisions, are important to permit the minority member more effective participation.
To this last point, it would likely be more palatable to other members if the consent of the manager designated by the minority member were required for only a limited number of decisions. These could include matters such as changing the company’s purpose, borrowing or expending money over a certain amount, pledging the company’s assets, entering into certain contracts, major tax elections, compensation of managers or officers, right to maintain percentage interest in outstanding interests (anti-dilution), sale, merger or other transfer of operations/assets of the company, dissolution or bankruptcy of the company. The task will be to place restrictions on a limited number of decisions important for the minority member to realize the benefit of his/her bargain.
When considering the decisions and other actions of managers of the company, it will be important to understand their responsibilities to the company and its members. The LLC Act provides the default standards for the performance of the managers’ duties and the right of those holding those positions to be indemnified by the company. As in most areas of the LLC Act, these points can be modified by the members. For example, the statutory duties of good faith, fair dealing and acting in the best interests of the company can be limited, if not eliminated. A minority member needs to consider the result of these provisions and decide how much latitude will be allowed the managers. Once this is established, the indemnification provisions should be reviewed to make them consistent with the intent of those modifications. If a manager’s liability is going to be limited, the minority member may want to be sure those same managers are not indemnified from their own bad acts.
The initial capitalization of the entity is established upon its creation. Many businesses thereafter find additional capital necessary to prosper, and perhaps even to survive. The Operating Agreement should include the requirements for any capital call and any borrowings that could require the personal guaranty of a minority member, and consideration should be given to limits on such funding events, such as providing for the minority member’s participation only upon his/her consent.
The organization of a new company is almost always based upon the members’ expectation that they will be involved in a profitable enterprise leading to cash distributions. The decision to make distributions is often within the general discretion of the managers, but provisions can be included requiring distributions of available cash generated from both normal operations, as well as extraordinary events, such as the sale of the business. While those operating the business need some flexibility in maintaining operating reserves, provisions can be added that will keep controlling members/managers from abusing their general authority. This will be extremely important for minority members since most limited liability companies have all their profits taxed directly to their members. Accordingly, minimum distributions should at least cover the potential tax on income that will be passed through to members. It is not unusual to require annual distributions in the amount of the maximum tax rates times the income deemed distributed to each member. The absence of such a provision could result in the minority member not having funds to pay the tax on the taxable income he/she is deemed to have received from the company.
It may also be helpful for minority members to have the rights to periodic reports and to inspect the books and records of the company. While the LLC Act provides some protections, they are subject to certain restrictions and limitations. Consideration should be given to setting out specific reports and inspection rights for all members. Access to frequent financial reports and the right to inspect company books/records will help ensure transparency of management and may also avoid misunderstandings or damaging expectations.
TRANSFER AND EXIT
Transfer restrictions are typically included in Operating Agreements giving the members comfort they can control the identity of their fellow members. There are a wide range of provisions that give the members rights to buy membership interests before they can be acquired by “outsiders”. While these generally give all members the right to maintain their respective percentage interests in the company, care should be given to whether the minority member can realize the benefit of those rights. Especially from a timing standpoint, exercising these rights may be more challenging to some members than to others, and the minority member needs to have enough time to fund and close any purchase of interests.
At some point, the minority member may desire to transfer his/her interest to a spouse, child or other desired assignee. It is not unusual to provide in the Operating Agreement that a member may transfer an interest in the company to a “permitted transferee” without the intervening right of the other members to buy the interest. There may be some attendant requirements to protect the company, but the rights of the transferee as a full member or assignee are most often defined. Unless specially tailored, this right can be a double-edged sword and, in reaching any agreement on transfer rights, the minority member should take into account who might become the controlling member, including the “permitted transferees”. A minority member may also want to maintain the right to make a complete exit from the company at some future date. This could be accommodated by a “put” right requiring the company or the other members to purchase the member’s interest and setting out the process and price for the exiting member. These provisions usually strike a balance between the benefit to the exiting member and the burden placed on the company as to the price and timing of the payments. Issues of importance in this setting are the purchase price and the payment of the purchase price. The minority member will want to avoid any attempted application of minority and lack of marketability discounts and having deferred purchase price payments without collateral or personal guaranties.
Consideration should be given to providing a “tag along” right for the minority member which would enable the minority member to require the purchaser of a controlling interest in the company to purchase the minority member’s interest on the same terms including price as the controlling price is purchased. If such a “tag along” right is negotiated, it is likely that the controlling interests will require a corresponding “drag along” right which would enable the seller(s) of the controlling interests to require the minority members to sell their interests on the same terms as the controlling interests. Exercise of these rights could avoid the minority members being left behind if the business is sold through the acquisition of membership interests but, on the other hand, it could also result in the minority member being bought out of a successful profitable business.
ADDITIONAL MISCELLANEOUS RIGHTS
An Operating Agreement typically contains a provision dictating how the agreement may be amended, and it is not unusual for amendments to be limited to those agreed to by all members. However, if there is some lower standard such as the vote of a majority of ownership interests, the minority member should consider some veto power over amendments to specific protective provisions, such as the right to designate a manager or a more generic limitation such as those changes that would negatively affect his/her financial terms/benefits. Consideration may also be given to include any desired rights of assignees (as opposed to members) to participate in or veto amendments.
It is not uncommon for members to have other businesses that operate in the same or a related industry as the company. A minority member may find comfort in including a provision in the Operating Agreement permitting the minority member to operate in the same industry without liability or owing an accounting to the company or other members. On the other hand, a minority member may want to include specific provisions restricting other owners from competing with the company.
Finally, although it is always hoped that disputes will not arise, it is wise to consider how and where the parties would want to resolve problems among them in connection with the company. The Operating Agreement can establish the procedure for a member questioning the actions of the managers, or otherwise resolving disputes. Litigation, arbitration, and mediation are the main alternatives and it is often desirable in entities with a small number of members to establish a period to act in good faith to resolve the dispute, before moving to one of the more formal procedures. The minority member may also want to include some buy-out or “put” rights if disputes are not resolved to his/her satisfaction. In any event, it will be helpful to have some preexisting approach agreed upon to control the proceedings in a way acceptable to all the members and hopefully more likely to succeed.
When using a limited liability company as the commercial entity of choice, minority members will want to consider and use appropriate documentation to protect their rights and realize the benefit of their bargain. The variety and breadth of these protections are as infinite as the imagination of those creating the entities. We hope this will provide a starting point for recognizing the value of those safeguards and implementing them.