Shareholder Agreement Type Provisions for Limited Liability Companies

January 2006

Limited liability companies, also known as "LLCs", and their members can benefit from the same types of provisions that are found in the shareholder agreements of corporations; however, care must be used when applying shareholder agreement-type provisions to agreements in the LLC context to ensure that valuation formulae work when there are variances in capital accounts and other attributes of the members.

Ever since the limited liability company was first officially recognized by the Internal Revenue Service in 1988 as a "pass through" entity for federal tax purposes, the LLC has become more and more popular as a vehicle for new businesses. The primary reason for this trend is the flexibility the LLC provides, particularly with respect to tax planning; however, the flip side to this increased flexibility is that when the governing documents of the LLC do not address an issue, there is much less statutory and common law guidance upon which to rely. Additionally, the fungibility of stock that is ubiquitous in the context of corporations does not necessarily apply in the context of LLCs, where different membership interests may have vastly different values per profit interest as a result of differences in capital accounts, management rights, contribution obligations, tax attributes and other rights and obligations.

Below are descriptions of several types of provisions commonly used in shareholder agreements that can also be useful to limited liability companies, along with valuation specific items to consider when applying these concepts in the LLC context. These provisions can be incorporated in a member's agreement, but the more common practice is to include them in the LLC's operating agreement.

In reviewing these various provisions, keep in mind new members should always be required to sign the LLC operating agreement to ensure that all the operating agreement provisions are enforceable against them.

BUY-SELL PROVISIONS IN THE CONTEXT OF INVOLUNTARY TRANSFERS

The term "buy-sell" is often used loosely in the context of shareholder agreements to include two different concepts. The first of these is the obligation of a member to sell, and/or the company to buy, the interest of a member upon an involuntary transfer of that member's interest, usually upon death, and frequently, upon divorce, bankruptcy or termination of employment. These provisions are often used as an estate planning tool to provide a way to monetize a member's interest in a limited liability company upon death for purposes of paying estate taxes. In order to fund the buy-out, corresponding life insurance policies may be purchased by the company that give the company the financial wherewithal to purchase the interests of the deceased member. The same goal may also be accomplished by the use of a sinking fund whereby the company, or other members, pay into a fund that is used to purchase a member's interest upon that member's death. Similar provisions may apply, at the company's option, upon other involuntary transfers such as the divorce or bankruptcy of a member or upon the termination of a member's employment by the LLC. The purpose of these provisions is to keep the transferring member's interest from transferring to (or in the case of a termination, staying with) a party with whom the other members would prefer not to be associated.

In both the corporate shareholder agreement and the LLC operating agreement context, these types of buy-sell provisions will require either a set formula agreed to beforehand in the agreement, or an appraisal at the time of the transfer, to value the interest because there is no third party valuation upon which to base a valuation of the interests. If a formula is used, it needs to take into account capital accounts and other unique attributes of the interest being purchased. Such a formula can be based on a number of benchmarks. Book value is often used but is usually punitive as it does not take into account the going concern value of an entity. A multiple of trailing earnings is often a more fair approach but a multiple chosen of one point in time may not be accurate at another time when risks and market conditions are much different. It is also possible to use different formulae in different circumstances. For instance, book value might be used for a buy-out when an employee leaves voluntarily or is dismissed for cause but a multiple of earnings could be used for termination without cause or death. In each case, however, one should consider whether a capital account adjustment is necessary in applying a formula.

TEXAS SHOTGUN (YOU CUT I CHOOSE)

The second type of "buy-sell" clause, is also referred to as a "Texas shotgun." In a Texas shotgun, one member picks a price at which he will buy out the other member. The other member can either accept the offer and sell his interest at that price or buy the offering member's interest at the same pro rata price. A Texas shotgun can be used in a two member corporation or LLC to provide a way for either owner to buy out the other. The arrangement can also be used where there are more than two members but its application becomes much more cumbersome. Often, but not always, the provision requires some type of deadlock before the procedure can be invoked. In the corporate situation, valuation of the purchased interest is relatively easy because a per share price can be used; however, in the context of an LLC, there may be variations in capital accounts, voting rights, rights to losses and so forth that do not make a percentage profits interest of one partner readily comparable to the valuation of the second member's interest. This is best dealt with in an LLC by requiring the offering member to make an offer based on the value of the entire entity. Then, the sale price of a member's interest can be calculated by using the distribution upon liquidation mechanism contained in the operating agreement to determine what the selling member would receive had the business been sold for the entire amount. If the members do not believe that the liquidation provisions provide the appropriate mechanism for valuing the selling member's interest in this scenario, one of the formulae described below in the description of tag-along and drag-along provisions could be used.

Another issue to keep in mind in determining whether to use a Texas shotgun arises when there is a disparity of economic means between the members. If one member does not have the means to make a purchase at anywhere near the actual value, it puts the other member at a tremendous advantage. This can, however, be mitigated by using earnouts or notes payable to finance the purchase, but these should be called out in the agreement.

DRAG-ALONG AND TAG-ALONG PROVISIONS

The problem of valuing a selling member's interest is most difficult in the context of drag-along and tag-along provisions. A drag-along provision provides that, if members with greater than a specified threshold of ownership in the entity, usually 50%, have identified a buyer and desire to sell their outstanding interests in the company to that buyer, then those selling members can force the other members to sell their interests at the same pro rata price. This mechanism prevents minority shareholders from "holding out" thereby derailing a transaction when a buyer does not want to be subject to the interest of minority owners. Conversely, a tagalong allows a minority owner the right to participate in a transaction at the same pro rata price of other owners where a threshold interest is being transferred. This allows a minority member to have the opportunity to monetize his interests along with the majority owners. The rub in each case is determining what the "same pro rata price" is where the membership interests have varying capital accounts, management rights and other features. An appraisal based on the price for which the buyer is willing to purchase the selling member's interest adjusted for the differing features is the most accurate approach, but this adds additional time and cost to a transaction.

Another approach is to use a variation on the liquidation valuation described above with respect to Texas shotgun provisions. To apply this approach one must calculate the full entity valuation based on the value of the interest being sold that is triggering the drag along; in other words, what full entity valuation would result in a liquidation value of the seller's interest equal to the offer the seller has received? Once this whole entity value is established, then the value of the interest being dragged along can be determined applying the liquidation provisions. If more than one member is part of the selling group and they are not receiving proportional offers for their interests then a weighted average based on profits interests can be used.

A straight percentage profits interest approach which does not take capital accounts into consideration may also be used, but this can produce a windfall for "sweat equity" members who have not contributed a proportional amount of the company's financial capital.

To make the drag-along and tag-along arrangements work, some method for valuing the interest should be agreed to in advance. An "agreement to agree" on the price at the time the deal is made is a recipe for litigation because it tends to give hold out power to minority members.

RIGHTS OF FIRST REFUSAL

The limited liability company ownership interest right of first refusal is the provision of this type that is least different from its corporate counterpart. A right of first refusal means, as the name implies, that if a party receives an offer from a third party to purchase its interest in the entity, it must first offer that interest to the other members of the entity, or to the entity itself, on the same terms that it wishes to sell to the third party buyer. Valuation issues pertaining to capital accounts and various management rights are not implicated in this scenario because the price is for just that set of rights and no other; therefore adjustments are not required. The same is true of a right of first offer whereby a selling member must offer the interest to other members before offering it for sale to third parties.

CONCLUSION

Shareholder agreement-type provisions can be very helpful in the context of an LLC; however, these provisions cannot be cut and pasted directly into the LLC's operating agreement; drafters must be careful to address areas where stock and LLC profit interests are different to ensure appropriate results arise from the application of these provisions.

	Contact Us Services Attorneys News and Events Publications About the Firm Inclusiveness Careers Blog In the Media Events and Registration Press Releases Speaking Engagements Articles Client Advisories Subscriptions History Offices Pro Bono Interlaw Contact Us Culture Legal Opportunities Support Staff Publications Client Advisories Home > Publications > Client Advisories > View Shareholder Agreement Type Provisions for Limited Liability Companies January 2006 by James R. McMaster and Michael Dubetz (303) 299-8005 jmcmaster@sah.com (303) 299-8164 mdubetz@sah.com Limited liability companies, also known as "LLCs", and their members can benefit from the same types of provisions that are found in the shareholder agreements of corporations; however, care must be used when applying shareholder agreement-type provisions to agreements in the LLC context to ensure that valuation formulae work when there are variances in capital accounts and other attributes of the members. Ever since the limited liability company was first officially recognized by the Internal Revenue Service in 1988 as a "pass through" entity for federal tax purposes, the LLC has become more and more popular as a vehicle for new businesses. The primary reason for this trend is the flexibility the LLC provides, particularly with respect to tax planning; however, the flip side to this increased flexibility is that when the governing documents of the LLC do not address an issue, there is much less statutory and common law guidance upon which to rely. Additionally, the fungibility of stock that is ubiquitous in the context of corporations does not necessarily apply in the context of LLCs, where different membership interests may have vastly different values per profit interest as a result of differences in capital accounts, management rights, contribution obligations, tax attributes and other rights and obligations. Below are descriptions of several types of provisions commonly used in shareholder agreements that can also be useful to limited liability companies, along with valuation specific items to consider when applying these concepts in the LLC context. These provisions can be incorporated in a member's agreement, but the more common practice is to include them in the LLC's operating agreement. In reviewing these various provisions, keep in mind new members should always be required to sign the LLC operating agreement to ensure that all the operating agreement provisions are enforceable against them. BUY-SELL PROVISIONS IN THE CONTEXT OF INVOLUNTARY TRANSFERS The term "buy-sell" is often used loosely in the context of shareholder agreements to include two different concepts. The first of these is the obligation of a member to sell, and/or the company to buy, the interest of a member upon an involuntary transfer of that member's interest, usually upon death, and frequently, upon divorce, bankruptcy or termination of employment. These provisions are often used as an estate planning tool to provide a way to monetize a member's interest in a limited liability company upon death for purposes of paying estate taxes. In order to fund the buy-out, corresponding life insurance policies may be purchased by the company that give the company the financial wherewithal to purchase the interests of the deceased member. The same goal may also be accomplished by the use of a sinking fund whereby the company, or other members, pay into a fund that is used to purchase a member's interest upon that member's death. Similar provisions may apply, at the company's option, upon other involuntary transfers such as the divorce or bankruptcy of a member or upon the termination of a member's employment by the LLC. The purpose of these provisions is to keep the transferring member's interest from transferring to (or in the case of a termination, staying with) a party with whom the other members would prefer not to be associated. In both the corporate shareholder agreement and the LLC operating agreement context, these types of buy-sell provisions will require either a set formula agreed to beforehand in the agreement, or an appraisal at the time of the transfer, to value the interest because there is no third party valuation upon which to base a valuation of the interests. If a formula is used, it needs to take into account capital accounts and other unique attributes of the interest being purchased. Such a formula can be based on a number of benchmarks. Book value is often used but is usually punitive as it does not take into account the going concern value of an entity. A multiple of trailing earnings is often a more fair approach but a multiple chosen of one point in time may not be accurate at another time when risks and market conditions are much different. It is also possible to use different formulae in different circumstances. For instance, book value might be used for a buy-out when an employee leaves voluntarily or is dismissed for cause but a multiple of earnings could be used for termination without cause or death. In each case, however, one should consider whether a capital account adjustment is necessary in applying a formula. TEXAS SHOTGUN (YOU CUT I CHOOSE) The second type of "buy-sell" clause, is also referred to as a "Texas shotgun." In a Texas shotgun, one member picks a price at which he will buy out the other member. The other member can either accept the offer and sell his interest at that price or buy the offering member's interest at the same pro rata price. A Texas shotgun can be used in a two member corporation or LLC to provide a way for either owner to buy out the other. The arrangement can also be used where there are more than two members but its application becomes much more cumbersome. Often, but not always, the provision requires some type of deadlock before the procedure can be invoked. In the corporate situation, valuation of the purchased interest is relatively easy because a per share price can be used; however, in the context of an LLC, there may be variations in capital accounts, voting rights, rights to losses and so forth that do not make a percentage profits interest of one partner readily comparable to the valuation of the second member's interest. This is best dealt with in an LLC by requiring the offering member to make an offer based on the value of the entire entity. Then, the sale price of a member's interest can be calculated by using the distribution upon liquidation mechanism contained in the operating agreement to determine what the selling member would receive had the business been sold for the entire amount. If the members do not believe that the liquidation provisions provide the appropriate mechanism for valuing the selling member's interest in this scenario, one of the formulae described below in the description of tag-along and drag-along provisions could be used. Another issue to keep in mind in determining whether to use a Texas shotgun arises when there is a disparity of economic means between the members. If one member does not have the means to make a purchase at anywhere near the actual value, it puts the other member at a tremendous advantage. This can, however, be mitigated by using earnouts or notes payable to finance the purchase, but these should be called out in the agreement. DRAG-ALONG AND TAG-ALONG PROVISIONS The problem of valuing a selling member's interest is most difficult in the context of drag-along and tag-along provisions. A drag-along provision provides that, if members with greater than a specified threshold of ownership in the entity, usually 50%, have identified a buyer and desire to sell their outstanding interests in the company to that buyer, then those selling members can force the other members to sell their interests at the same pro rata price. This mechanism prevents minority shareholders from "holding out" thereby derailing a transaction when a buyer does not want to be subject to the interest of minority owners. Conversely, a tagalong allows a minority owner the right to participate in a transaction at the same pro rata price of other owners where a threshold interest is being transferred. This allows a minority member to have the opportunity to monetize his interests along with the majority owners. The rub in each case is determining what the "same pro rata price" is where the membership interests have varying capital accounts, management rights and other features. An appraisal based on the price for which the buyer is willing to purchase the selling member's interest adjusted for the differing features is the most accurate approach, but this adds additional time and cost to a transaction. Another approach is to use a variation on the liquidation valuation described above with respect to Texas shotgun provisions. To apply this approach one must calculate the full entity valuation based on the value of the interest being sold that is triggering the drag along; in other words, what full entity valuation would result in a liquidation value of the seller's interest equal to the offer the seller has received? Once this whole entity value is established, then the value of the interest being dragged along can be determined applying the liquidation provisions. If more than one member is part of the selling group and they are not receiving proportional offers for their interests then a weighted average based on profits interests can be used. A straight percentage profits interest approach which does not take capital accounts into consideration may also be used, but this can produce a windfall for "sweat equity" members who have not contributed a proportional amount of the company's financial capital. To make the drag-along and tag-along arrangements work, some method for valuing the interest should be agreed to in advance. An "agreement to agree" on the price at the time the deal is made is a recipe for litigation because it tends to give hold out power to minority members. RIGHTS OF FIRST REFUSAL The limited liability company ownership interest right of first refusal is the provision of this type that is least different from its corporate counterpart. A right of first refusal means, as the name implies, that if a party receives an offer from a third party to purchase its interest in the entity, it must first offer that interest to the other members of the entity, or to the entity itself, on the same terms that it wishes to sell to the third party buyer. Valuation issues pertaining to capital accounts and various management rights are not implicated in this scenario because the price is for just that set of rights and no other; therefore adjustments are not required. The same is true of a right of first offer whereby a selling member must offer the interest to other members before offering it for sale to third parties. CONCLUSION Shareholder agreement-type provisions can be very helpful in the context of an LLC; however, these provisions cannot be cut and pasted directly into the LLC's operating agreement; drafters must be careful to address areas where stock and LLC profit interests are different to ensure appropriate results arise from the application of these provisions. Copyright 2000-2013 Sherman & Howard L.L.C. All rights reserved. Privacy Policy \| Terms of Use