The 5 Common Multi-Member LLC Traps
There is a
popular saying among attorneys and it is “partnerships are sinking
ships.” Unfortunately, this saying has a lot of merit in the
business world. Anytime one decides to start a business venture
with another person, there is a more than 75% chance that the two
people will eventually have fundamental and disruptive business
disputes related to the business.
I have heard that
there is a close to 50% chance that the business will fail not
because of the business itself but because of fighting and issues
between business partners. Litigation attorneys love these
statistics because business partner disputes create a lot of
business for them and their law firms.
For the new
business owner who is planning to go into business with a business
partner, the last thing on his or her mind is that anything will
ever go wrong: “Oh – John is my good friend and we will always be
able deal with any thing.”
I always try to
engrain a very fundamental philosophy into my new business owner
clients. If you do not plan, you are planning to fail. A business
needs prenuptial planning even more than marriages today! Here are 5
Traps that you should avoid if you are planning on starting a
multi-member LLC business:
Trap #1: Don’t Partner with
Strangers
Deciding on who
you are going to do business with is just as important as deciding
who will be your wife or husband. You need to do due diligence.
Talk to people that the proposed Member has done business with
before. Talk to his or her friends or co-workers. Really think
through whether you both have the right personalities to stay
together through good and bad times.
I have had many
clients (who come to me with partner disputes) tell me that they did
not have a good feeling in their guts when it came to their partner,
but they chose to ignore those feelings. If they had to do it over
again, they would have honored their gut feelings. Pay attention to
those signs at the beginning of a business relationship.
Starting a new
business is so rewarding, but it is also challenging and quite
stressful. Make sure that your partner business team understands
this and that each person has the right personality, business skills
and persistence to work with you through the trials and
tribulations. Almost every successful business I know has had to go
through stressful and uncertain times. These times and how
management and the Members choose to address the challenges actually
make the business a success!
Trap #2: Don’t Take the Admission of
New Members Lightly
Your LLC Operating Agreement Should
Have Restrictive New Membership Provisions
What happens when
one Member wants to admit a new partner to the LLC and another
Member does not want to? All new business partners need to discuss
this issue at the beginning of the business and decide how they want
to address this issue. Should a majority of the Members have to
agree? A supermajority? Or even a unanimous vote of all Members?
This is not an
easy decision. Often, when an LLC is considering admitting a new
Member it is because the LLC wants to raise money and receive funds
from a new Member in exchange for issuing a Membership Interest in
the LLC. If you require a unanimous decision, then if one Member
refuses to agree, it is possible the LLC will go bankrupt because it
is unable to raise the money it needs.
Trap #3: Don’t Allow the Free
Transferability of Membership Interests in your LLC- Your LLC
Operating Agreement Should Have Restrictive Provisions when it comes
to selling ownership interests in the LLC
Without proper
transfer restrictions in an Operating Agreement or other contract
among Members, there is nothing in the LLC laws that prevent a
Member of an LLC from transferring his or her ownership interests to
another party.
Let’s use an
example to explain how disastrous this can be. Assume you go into
business with your sister. Over time, your sister decides she wants
to spend more time with her family and the stress of the growing
business is too much for her. The next day you find out that she
has sold her Membership Interests in the LLC business to her
neighbor. You now have a new business partner and co-owner of your
LLC business. Even worse, the neighbor has fundamentally different
ideas about how the business should be managed.
All of these
issues can be avoided by having the proper transfer restriction
provisions in the LLC Operating Agreement or by entering into what
is known as a Buy Sell Agreement among Members.
Trap #4: Be careful who you give
LLC Authority to
Did you know that
the LLC laws include certain “agency laws” that you should know
about? These agency laws say that in a member managed LLC, if an
LLC Member enters into contract obligations or agrees to other
liabilities on behalf of the LLC, then the LLC is liable for those
obligations and liabilities. What if the LLC Member owned only 1%
of the LLC and did not have any real authority to do so? It does
not matter- the LLC will still be on the hook in most cases.
So, you always
need to be sure that your LLC Member partners are trustworthy and
that the LLC Operating Agreement has clear provisions setting forth
a structure for when an LLC Member has or does not have authority.
If you have concerns about authority with Members, there is a
planning method that can be used to avoid these risks.
Trap #5: Don’t Forget to Document
Everything
When a marriage
ends up in a nasty divorce, the situation becomes a major “he said
she said” battle. That battle ends up costing the man and woman
thousands of dollars in legal fees.
This same battle
occurs in many business partner disputes. An LLC Member will claim
that the other Member agreed to something that the other Member
disputes. Or a minority Member will claim that the majority Member
of an LLC abused her discretion by not following the LLC governance
rules.
In a business
LLC, this battle can be greatly minimized because an LLC should
document all LLC decisions. LLC decisions are documented in written
LLC resolutions and all LLCs should have LLC resolutions to document
all major LLC decisions and decisions among LLC Members.
