LEGAL GUIDE
Written by attorney Seth Hamilton Kramer | Aug 23, 2010

The Importance of a Limited Liability Company Buy-Sell Agreement

A Buy-Sell Agreement (http://www.yoursmallbusinesslawyer.com/faqs/how-can-a-properly-drafted-buysell-agreement-bsa-protect-my-business-interests.cfm) (“BSA") lets business owners plan thoughtfully in advance what will happen when a co-owner voluntarily or involuntarily ceases to become a member of an LLC. It may help to think of a buyout agreement as a sort of “prenuptial agreement" between business owners: it provides the ultimate risk-reducing business exit strategy which protects against conflict and cost in the event that they became at odds and desperately need a “company divorce". Simply put, It’s a huge mistake to ignore the fact that sooner or later business relationships change.

Unfortunately, many new owners neglect to negotiate a comprehensive BSA during formation of an LLC. As a result, minor disputes often escalate into company-destroying conflict. Worse, absent this essential mechanism for the orderly acquisition of the membership interest of a member of the LLC upon the happening of a specified triggering event, hostile owners may find themselves permanently stuck together without a way to disassociate.

A buyout agreement can stand on its own or can be several provisions in an LLC/Operating Agreement (http://www.yoursmallbusinesslawyer.com/faqs/should-my-llc-have-a-written-operating-agreement-and-if-so-what-should-it-contain.cfm) that control the following business decisions:

  • Whether a departing member must be bought out;
  • What price will be paid for the departing member’s interest in the LLC;
  • Who can buy the departing member’s interest in the LLC (and whether such interest will include full membership rights or be restricted to an economic interest); and
  • What events may trigger a buyout.

Common events that can trigger a buy-out of a member include:

  1. Any event chosen by the members: Each LLC/Operating Agreement with Buy-Sell provisions may include any triggering events that are important to the members.

  2. Death of a member: The LLC or surviving member purchases the interest of a deceased member. Mandatory buy-outs after a death can be funded with life insurance on the lives of the members.

  3. Divorce: This prevents the wrong spouse from acquiring an interest in the LLC if two members own their interest as community property and they get divorced and the wrong spouse becomes the sole owner of all or a portion of the membership interest.

  4. Termination of employment: This is especially important when the employee is a minority member and should only own an interest while employed.

  5. Default under the LLC/Operating Agreement: This allows the LLC or other members of the company to purchase the membership interest of a member who defaults under a particular provision of the LLC/Operating Agreement, for example, if a member fails to make a required contribution of money or property.

  6. Sale of majority of the company: Commonly referred to as a “Drag Along" Provision, this event gives a majority member the option to require minority members to sell their membership interests in the LLC if the majority member sells to an outside party. The sale of the minority members' interests are on the same terms and conditions as the sale of the majority member's interest.

  7. Sale of majority of the company: Commonly referred to as a “Tag Along" provision, this event gives minority members have the option to require the majority member to include the sale of the minority members' membership interests in the LLC if the majority member intends to sell its interest to an outside party. The sale of the minority members' interests must be on the same terms and conditions as the sale of the majority member's interest.

  8. Transfer of membership interest without consent of the members: The company’s LLLC/Operating Agreement should provide that a member may not transfer or encumber all or any interest in the member's interest in the company without the approval of the members and that his membership interest remains in compliance with the terms and conditions of the LLC/Operating Agreement. If a member violates the no transfer/encumbrance provisions, the LLC should have an option to acquire the interest of the defaulting member.

  9. Loss of professional license: This provision is commonly used for LLC's that are owned by members who are required by law to be licensed in a particular field.

  10. Disability: This provision is used to acquire the interest of a member who become permanently disabled and unable to provide necessary services for the LLC.

  11. Retirement: The disassociation of a retiring member from an LLC is complicated without an LLC/Operating Agreement with Buy-Sell provisions.

  12. Bankruptcy: If a member loses the member's interest in the LLC because of filing for bankruptcy, the company and other members may be able to buy the interest from the creditor who acquires it out of the bankruptcy.

One final note: After the members decide which triggering events to include in a BSA for their LLC, they must then decide which events result in mandatory acquisitions and which events merely give the company and other members an option to purchase

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