Structure of Limited Liability Companies

---

Management

An LLC offers flexible management choices. These include “member-managed” and “manager-managed.” A member-managed LLC is one in which all of the owners (members) manage the LLC. For example, let's say that Paul Prescott and his brother, Peter, decide to start a printing business. They form an LLC in which both will be active in running the business and will put up cash or property to start the business. In this case, they would form a member-managed LLC since both will participate in the ownership and management of the business.

In a manager-managed LLC, one or managers are given the management responsibility for the LLC. The managers are not required to be members. Where would this situation occur? Let’s go back to Peter and Paul. Their business, Prescott Printing, LLC, has now grown. They need to hire more employees and buy more equipment. They turn to their friend, Perry, who is willing to invest in the business. Perry wants some voice in the operation of the business but doesn’t want to be involved in the day-to-day operations. The solution is to make Peter and Paul the managers with the responsibility of running the business on a day-to-day basis and make Perry a nonmanaging member.

Now let’s change the example a bit. Let’s say that Paul is the father of Peter and Perry. He wants his sons to have an ownership interest in the business but Paul still wants to make all the decisions. By setting up a manager-managed LLC with all three as members but only Paul as the manager, Paul retains the responsibility for managing the daily operation of the business. In this example, Paul operates more like the president or CEO in a corporation.

Paul would have to be careful in this situation, however. Nonmanaging members are still given certain rights by statute, including the right to remove managers and to vote on certain matters, such as the admission of new members or the sale of membership interests. The provisions of each state will vary, and certain limitations can be placed on the rights of members by a written operating agreement entered into by the members.

Important note: the selection of either member-managed or manager-managed will not affect the limited liability protection of the members.

Number and Type of Members and Managers

With the exception of Massachusetts and the District of Columbia, all states permit LLC’s to be formed with just a single member. There is no limit on the number of members that an LLC may have. There are also no restrictions on who may be a member in an LLC, which may include individuals, non-resident aliens, corporations and other LLC’s.

The same rules apply for managers, who may be as few as one or unlimited in number. However, since managers are typically given specific responsibilities and must generally have majority agreement on decisions, it may become impractical and cumbersome to have more than a few managers in an LLC.

Meetings of Members and Managers

Like California, most states have no formal requirements for meetings of members or managers. Some states do require annual meetings unless a formal operating agreement dispenses with such meetings.

In a smaller LLC, like a smaller corporation, with just a few individuals involved as principals, there is generally no reason to have formal meetings to make decisions. While most LLC statutes omit any such meeting requirements, virtually all state statutes also permit smaller corporations to dispense with formal meetings and take action by written consent.

In an LLC with a larger number of managers and members involved, it may be necessary to hold a meeting in order to vote on important business decisions, such as the merger with another company, signing a major contract, or accepting contract terms on a major transaction. It may be equally important to have minutes or similar recorded notes of the discussion and results of the vote or decision reached.

Voting Rights of Members and Managers

In most states, the voting rights of members are identical to their ownership percentage in the LLC. Therefore, a member with a 75% membership (ownership) interest has 75% of the voting power of the LLC. In most cases, the members would expect that their voting interest would be the same as the percentage of their capital contribution to the LLC. They have the flexibility, however, to change this in a written operating agreement.

Let’s say that four entrepreneurs decide to open a trendy new restaurant. They each agree to put up equal cash contributions for equal (25%) voting rights as the members of the LLC. They hire Francois Billet, a chef with a top reputation, as their head chef. Francois will not put up any money, but he wants voting power in the LLC since his reputation will be on the line and he wants to participate in major decisions. To give Francois a voting right as a nonmember, the LLC chooses to be manager-managed instead of member-managed. Francois and the four members operate as the five managers of the LLC. The operating agreement states that all major decisions require an 80% majority vote of the managers. This gives equal voting power to all four members and Francois, and the 80% requirement makes each vote more important than if only a simple majority vote were required.

In this scenario, the parties enter into a written operating agreement that changes the default state provisions that would otherwise regulate the operation of their LLC. First, they have provided that voting rights will not follow the same percentages as capital contributions. They have also imposed a requirement for an 80% majority vote on certain major decisions, where state statutes often require only a simple majority vote.

---

Governing Instruments

Articles of Organization

An LLC, like a corporation, is a state-approved and state-regulated entity. It is formed by filing a document called Articles of Organization, Certificate of Existence or similar name. We’ll simply refer to it as the Articles of Organization.

States typically require very little information to be supplied on the Articles of Organization. This will include the name of the LLC, its principal business address, the name and address of the registered agent, and whether the LLC will be member-managed or manager-managed. Upon filing the Articles of Organization with the state’s appropriate agency, typically the Secretary of State, and payment of the required filing fee, the LLC is legally created.

If you will be forming a single member LLC, this is generally all that will be done a far as the governing instrument of your LLC. There will be no reason to enter into an operating agreement since there are no other members to consider with regard to voting rights, transfers of interests, admission of new members, etc. In this case, your LLC will be regulated by your state’s default provisions (provisions that apply when there is no operating agreement).

Operating Agreements

When an LLC has two or more members, or when it is manager-managed, it is advisable to have a written operating agreement. Why? As mentioned above, unless the members have entered into a written operating agreement, a state’s statutory provisions will regulate the operation of an LLC. This often will not comport with how the members would have chosen to operate the LLC or resolve a particular dispute.

Let’s start with a member-managed LLC, one in which the members have equal responsibility for running the LLC. While the list of topics that would often be covered by an operating agreement is lengthy, the following are major ones:

We’ll take a look at each of these topics in the pages that follow. If you want to jump ahead, simply click on any of the linked topics above to go directly to that discussion.

One of the first responsibilities of the members is to make their capital contributions to start the LLC and provide it with working capital. The greater the number of members, the more important it is to spell out what each member will contribute and set a date for when such contribution will be made.

It may be that the LLC’s business runs short on cash, or perhaps business is growing and it needs capital to expand. Will the members have an obligation in these circumstances to contribute additional capital beyond what they committed to at the formation of the LLC? This needs to be covered by the operating agreement. If future contributions will be required, the agreement should state whether future contributions will be unlimited or whether there will be some limitation, such as a percentage of the original contribution of each member or a maximum dollar amount. It should also specify the vote required for activating the additional contribution obligation.

The agreement must also describe the penalties for a member who fails to contribute his required share of an additional contribution. Will he be required to involuntarily sell his membership interest to the remaining members? Will the non-contributing member simply have his membership percentage reduced to reflect the total contributions made by all members? Will the non-contributing member have the right to make his required additional contribution at some future time and be “reinstated” to his full membership percentage?

We discussed how the members of an LLC might want to alter their voting rights in an earlier part of this section. The provisions of some states grant each member one vote without regard to the capital contributions made by each member. If this is not the intention or desire of the members, they would need to enter into a written operating agreement to change the state’s provisions and agree, for example, that each member will have a voting power equal to his membership interest in the LLC.

It may be that one individual will be recognized for his extensive experience and knowledge about the business of the LLC and thereby be given a greater voice in the operation than his membership interest would provide. Let’s return to our example with the four entrepreneurs and Chef Francois opening an new restaurant. Rather than establishing a manager-managed LLC that makes Francois a nonmember manager, it might be that because of the extensive experience of Francois in managing restaurant operations in addition to his culinary talents, he is given a disproportionately higher voting power, even a veto power, on certain major decisions of the LLC. Perhaps Francois must agree on the maitre de that the restaurant will hire; or must approve the pricing on the restaurant’s menu; or must consent before any additional restaurant location will be added.

This voting power can only be provided in a written operating agreement since the default provisions of state statutes will never address such specific situations.

What happens if you want to use half of the profits from the business to expand it or purchase some expensive equipment, but the other member needs the money personally and wants all the profits distributed to the members? Perhaps it’s only a question of timing for the distribution of profits: one member wants profits distributed monthly, but you aren’t so certain about how sales or cash flow might be next month, or quarter. You’d rather be more conservative and distribute profits less frequently, or in a lesser amount. How do you handle this?

If you look to your state’s default provisions to resolve this dispute, you’re likely to find that it says that the profits of the LLC are to be distributed in such amounts and at such times as a majority of the members agree. That’s no help here, since there are only two members and no majority vote exists. These are matters that are easily addressed at the time the LLC is formed by preparing a written operating agreement rather than waiting until it becomes a dispute.



There are many other factors that you will want to consider for your operating agreement concerning the allocation and distribution of profits. For example, let’s say that one member is a wealthy individual with other sources of income while the other members are younger, in lower tax brackets and have no other income sources. It is expected that the LLC will have a tax loss during its first year. This loss may be of little value to the younger members since they don’t have the income to utilize the loss. The wealthy member can use this loss to offset the taxes that would otherwise be paid on his other income. An agreement by the members can provide the wealthy member with a greater percentage of the loss than he would otherwise receive based on his membership interest.Concerning distributions of profits, members will always be required to report and pay taxes individually on their respective percentage of profits generated by the LLC’s business. This is not an issue as long as each member in fact receives such distribution. But tax law requires each member to pay income tax on his share of profits whether or not he actually receives a distribution of profits. If it is not the intention or desire of a member to pay income taxes on profits that he does not actually receive, then the only way to avoid this result is to ensure that a written operating agreement provides that the LLC is obligated to distribute to the members the full amount of their share of profits for which they will be required to pay income taxes.

What if there is a desire to expel one of the existing members. What events justify expulsion? Must there be “cause” or can a member be expelled for any reason (or no reason at all) so long as the required percentage of members vote for expulsion? If “cause” is required, what constitutes “cause?” No state’s default provisions will adequately answer these questions. The members must look to a written operating agreement to address these issues in a manner that truly reflects their desires.

When might a member be required to sell his membership interest to the remaining members? We touched upon one event earlier. If the LLC requires its members to make additional capital contributions, the penalty imposed on members who fail to make their contribution might be to sell their membership interest to the remaining members who make their additional contributions.

Other common events requiring an involuntary sale include the death of a member, the dissolution of marriage (to prevent a spouse from becoming a member without the consent of the other members), the personal bankruptcy of a member and a serious breach of the operating agreement by a member.

To provide for the involuntary sale of a membership interest and identify the specific events that will trigger a sale, the members must customize their operating agreement.

It may be that one of the members simply wants to sell his membership interest. Does he have an unrestricted right to do so? Do the other members have any right to buy the membership interest of the selling member to prevent a third party from becoming a member, and if so, on what purchase terms?

Many states, like California, divide a member’s interest in an LLC into two parts: a “membership interest” and an “economic interest.” A membership interest includes the right to participate in the management of the LLC’s business as well as voting rights. These rights are not part of an economic interest. An economic interest provides only the right to receive a proportionate share of the profits and losses of the LLC, as well as any other distributions to members, such as upon termination and liquidation of the LLC.

If the sale of an economic interest only is permitted by a state, it may be that the non-selling members have no desire to impose any restrictions on sale (and may not be permitted to impose restrictions) since the purchasing party will not have a membership interest and therefore has no right to participate in management or vote.

On the other hand, if a member wants to sell a full membership interest, the non-selling members generally want certain restrictions in place. First, there must be a vote of approval by the members. If more than a majority vote will be required, this generally must be specified in the operating agreement since state provisions typically will not require more than a simple majority vote. More fundamentally, the operating agreement might simply provide that members have no right to sell membership interests in the LLC—perhaps only economic interests.

Next, the non-selling members generally want the “right of first refusal” to purchase the interest of the selling member before a sale can be completed to a third party. This right of first refusal might give the non-selling members the right to purchase the interest on the same terms as the third party, or it might require a member to sell his interest based on some other agreed price or formula (the next section discusses valuation and pricing).

If a right of first refusal is desired, the procedure and timing for giving notice of an intended sale by the selling member, the timing for the non-selling members to respond and exercise their right of first refusal, and other related issues must all be personalized for each LLC in its operating agreement.

Let’s say the members have decided on the triggering events for the involuntary sale by an member and for a right of first refusal if a member voluntarily wants to sell his membership interest. How will you decide on the purchase price, that is, how do you determine how to value the membership interest? And what will the payment terms be?

There are a number of ways to value membership interests. Deciding which one is right for your LLC depends on the type of business you’re in and the personal preference of the members. The most common methods used to value a membership interest include:

This is the value of a membership interest on the books of the LLC at the time valuation is to be determined. It is an accounting principle that, simply stated, takes the initial cost of assets, adds items, such as improvements, that increase book value, and subtracts items, such as depreciation, that decrease book value.

Book value may not be the preferred method of valuing a membership interest since it generally will not reflect the value of intangible assets, such as good will or a patent held by a business.

As its name indicates, this is a value agreed to by the members. It may be a value agreed to at the time the operating agreement is signed, or it may be a value that the members agree to on a periodic basis.

In the first case, the operating agreement might provide, for example, that the value of a membership interest is the amount of a member’s initial capital contribution plus any additional contributions made and less any distributions of capital received by such member. It may provide that this number shall also be increased by 10% per year (or some other percentage) as a return on a member’s investment or capital contribution.

Alternatively, the members might agree that the initial value shall be an amount specified in the operating agreement, perhaps the amount of a member’s initial contribution, but that every year or two years the members shall agree upon a different value based on the changed financial circumstances of the LLC at that time. To protect against unintended results where the members fail to periodically update value, the operating agreement would typically provide either that the last agreed value would be used or, if the agreed value had not been updated for a certain period of time, then an alternative valuation method would have to be used, such as an appraisal, to determine the current fair market value.

Appraised value is a value determined by an independent appraisal of the business and the value of respective membership interests. An appraiser will commonly be requested to determine the fair market value of the business, that is, the amount that would be paid by a willing purchaser and the amount that would be accepted by a willing seller. This need not be the case if the operating agreement imposes different standards for determining value, or includes or excludes certain criteria that would normally be included in arriving a fair market value. For example, an appraiser might be instructed to apply a discount to the fair market value of a small, minority interest because of its lack of marketability. Alternatively, an appraiser might be told to consider adding a premium to a controlling majority interest in the LLC.

The members may prefer using appraised value because it is intended to determine value at the time of the triggering event that calls for valuation. It does not run the risk of being outdated as an agreed value does by being “stale” at the time of the triggering event, nor does it risk acting as a penalty by using book value that may disregard important valuation factors such as good will.

If the members choose appraised value as the valuation method, the following factors will also need to be addressed:

As you might expect, these are all decisions that are personal to each LLC and will not be adequately covered by reliance on default provisions in the statutes of any state.

Probably the least used of any of the valuation methods, formula value determines valuation based on an agreed, therefore predetermined, formula. The formula can be anything that the members agree to, but often it is simply a multiplier of the gross or net earnings of the business. Certain types of businesses have “established” multipliers that are used by business brokers and accepted by buyers and sellers of businesses.

For example, an escrow company may be valued at three times its annual gross income for the last 12 months, or perhaps multiplied by the average gross income received in the last 2, 3 or 5 years.

It may be common to value a liquor store at five times earnings, plus inventory, plus the fair market value of its liquor license.

Once the value of a selling member’s interest has been determined, there still needs to be agreement on the terms of payment. Will the member be paid all in cash? Will payment be part cash and part in a note? If so, what interest will be paid? Over how many years will the payments be made? Will the note be secured or unsecured? Will payments be made monthly, quarterly, yearly?

Unless these matters are covered by an operating agreement, they will not be adequately addressed by reliance on a state’s default provisions.

Additional Issues for a Manager-Managed LLC

In addition to all of the issues described above that should be covered in the operating agreement for a member-managed LLC, the agreement for a manager-managed LLC must also cover a number of matters relating to the manager(s), including:

Concluding Comments

A single member LLC, like a sole proprietorship, has only one owner and one manager. This simplifies the structure and makes a formal operating agreement unnecessary. When another member is added, or when an LLC is formed with multiple members, it is always advisable to have a written operating agreement to address the types of issues discussed above. The failure to do so will invoke a state’s default provisions, which often will impose a result that does not coincide with the intention of the members.

Our Opinion:  When one considers the cost of a lawyer to prepare a customized operating agreement, as would almost certainly be required, it is likely that the cost of forming an LLC would be substantially greater than forming a corporation. Any cost advantage that others have attributed to forming an LLC over a corporation will be eliminated when the cost of preparing a customized operating agreement is taken into account. In a corporation, the management issues are generally fully addressed in the bylaws and backed up by many years of legal decisions. No additional or supplemental documentation is required. If the shareholders decide to enter into a “buy-sell” agreement relating to the transfer of shares, the preparation of such an agreement should cost much less than an operating agreement since the scope of a buy-sell agreement is limited to one issue. An operating agreement should cover far more issues than simply the sale and transfer of membership interests and will necessarily be more costly to prepare. Aside from the cost factor, proponents of the LLC have identified the pass-through tax treatment of profits as an advantage over other entities, such as corporations. As discussed more fully in the section on Taxation of Limited Liability Companies, a corporation that elects “S” corporation tax status enjoys pass-through tax status that is substantially the same as afforded to LLC’s. While there are certain limitations on the maximum number of shareholders (75) and type of shareholder (generally, individuals) in an S corporation, these limitations normally do not come into consideration in smaller corporations. In short, when two or more members are forming an LLC, or when it is likely that a single member LLC will add a second member, serious consideration should be given to forming an S corporation and evaluating the costs and advantages and disadvantages that each has to offer in view of the nature of the business and the composition of the owners.