Short story: If you are a member of a multi-member LLC, make sure you and the other owners or members have an operating agreement to protect your interests.
Longer story: It’s complicated.
A lot of truth in the title of this post, a truth many owners of limited liability companies (“LLCs”) are unaware of, particularly those who share ownership with other members. After all, many assume, LLCs are easy peasy to set up: Reserve a name for the LLC, secure an EIN (if necessary), register the LLC with the Secretary of State (in Wyoming) or with the Department of Commerce’s Division of Corporations & Commercial Code (in Utah)–all for peanuts–and you’re off and running, organizational certificate in hand and all the liability protection that represents. Or if you’re short on time, any number of online service providers will do all that for you for a few additional peanuts. In either case, after literally minutes, your newly minted LLC will be ready to go. And you can get back to the real business of selling software or buying real estate or whatever else sits behind the liability shield you just set up.
Well, maybe, but again, maybe not. It depends, as they say.
I know; that’s not a very satisfying answer, but here’s the deal: If your LLC is a single-member LLC, that is, if you are the only owner, then maybe you’ve taken all the steps necessary to the formation of your LLC (more on this in another post). But if you’re just one of two or more members, you still have at least one more very important step to take: You and the other owners (aka “members”) of the LLC almost surely need what’s referred to as an Operating Agreement, an agreement between all the members of the LLC.
The operating agreement does what its name implies. It governs the operations, the daily ins and outs of the LLC, its ups and downs, its beginning and timely (or untimely) end. For example, the operating agreement can control if, when, and how new members can be admitted into the LLC. It can contain provisions that govern who manages the LLC and what powers they have or don’t have. Need power to make all decisions that involve less than $10,000.00? If the operating agreement says you’ve got it, well, you’ve got it. Power to sell the company to a suitor? Not without the consent of all the members, again, if the operating agreement says so. And so on. That’s the stuff an operating agreement is made of.
What? I Already Have an Operating Agreement?
Now it may come as a surprise to you that you already have an operating agreement, at least you do if you organized your LLC in Utah or Wyoming (and virtually every other state). The Limited Liability Company Acts of both states are essentially operating agreements. In fact, both acts say that “to the extent that [your own] operating agreement does not provide for a matter described in . . . this [act]. the [act] governs the matter.” Thus, the LLC Acts of both states are a sort of default operating agreement for those who never get around to having an attorney draft an actual operating agreement.
The target group of both states’s Limited Liability Company Acts was supposed to be small “entrepreneurs who organize their businesses without the benefit of [legal] counsel,” says Donald J. Weidner in his article LLC Default Rules Are Hazardous to Member Liquidity. At least that had been the objective of previous iterations of both Acts. The newest iterations? Not so much–and very much to the detriment of the unwary members of multi-member LLCs (“MMLLCs”).
So long and thanks for all the fish
As Weidner makes clear at the beginning of his article, the newest version of the Acts, versions that Utah and Wyoming enacted said so long to some protections tailored to the target group of small entrepreneurs. Instead, the new version,
(1) declared LLCs to be perpetual entities, and . . . (2) denied dissociated members both the right to dissolve and the right to be bought out. (3) It also took away their easy access to judicial remedies . . . (numbers added)
Let’s put some hypothetical meat on those abstract bones. Suppose you and your two best buddies form an LLC for the sole purpose of purchasing and managing a 4-plex in West Valley City, Utah, or Laramie, Wyoming. And suppose that things go great for a while. Real estate prices soar. Rents increase. Equity builds. But then, things change, at least for you. You and your family moved to another state. Your spouse is diagnosed with cancer. And right now, you’re just not that interested in part ownership of a 4-plex located in another state. You have other things on your mind.
So you ask your buddies to buy you out. Guess what: they have no obligation to do so, at least under the default “operating agreement” provided by the state’s LLC Act. In fact, you may have to wait until your buddies decide it’s time to dissolve the LLC and wind up its affairs–a time that could be years down the road, years after you really needed the money. Remember, that the life of your LLC is perpetual under the state’s LLC Act–unless your operating agreement says otherwise. Unfortunately, you and your buddies never drafted an operating agreement. In short, you’re kind of stuck.
Now, you’re not without any remedies. You might be able to sell your interest to an outside party. Of course, the person would have to buy knowing that she is buying only the rights to any distributions from the LLC and not necessarily for any voting rights or management rights. Good luck selling that.
You might also sue to force the dissolution of the LLC (thereby triggering distribution of your capital contribution) by proving that your buddies are “acting in a manner that is oppressive.” That, too, is a long shot unless they really are twisting the knife and not just exercising good business judgment under the circumstances. But if they’re simply not agreeing to buy you out because such a buyout would be a financial burden to them or the company, then oppression will be hard to prove.
So pick up the darn dollars.
There’s an old saying, don’t step over dollars to pick up dimes. Going bare, that is, setting up a multi-member LLC without an operating agreement that provides more flexible liquidity rights is picking up pennies. Just know that if you choose that route, down the road, you may find yourself battling for dollars with your former buddies because they don’t want to buy you out.
A well-drafted operating agreement can limit the life of the LLC if appropriate; it can provide for buyouts in the event of death, disability, or myriad other reasons; it can provide for judicial remedies not allowed under the default “operating agreement.” In fact, the operating can cover all kinds of bases, all sorts of contingencies that the state’s default agreement doesn’t even begin to address. In other words, a well-drafted operating agreement is a must have for multi-member LLCs.
And now you know how to avoid a world of hurt.
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