Sorting out your company’s owners’ exit strategy is one the most important considerations when forming an LLC. It may sound odd, but deciding how to get out of your small business in the beginning will save you and your business partners time and money down the road. When it comes to LLCs, one of the primary benefits is flexibility when drafting the operating agreement. This can be especially important when deciding on exit strategies, restrictions, and procedures for your small business. Today’s post highlights some of the more common exit provisions in an LLC operating agreement.
Buy sell provisions detail what will happen when a member of the LLC decides to leave the business, dies, or is otherwise unable to continue to participate as an owner of the LLC. One of the most common arrangements is the “right of first refusal.” This type of provision allows a member to sell its interest in the LLC to an outsider as long as the interest is first offered to the existing members of the LLC. If the remaining members choose not to purchase the interest, then the sale may proceed according to the terms of the operating agreement.
Common Ways for Members to Exit the Business:
Members of an LLC should specifically address the treatment of a member who decides to exit the company, or voluntarily departs. Are the members required to work for the company for a period of time before receiving their ownership interest? Another important consideration is whether you will include noncompete clauses in the operating agreement. A noncompete clause can protect your business against a departing member directly competing with your business.
It’s also important to include a process for valuing the departing member’s interest in the LLC. Deciding on a valuation method upfront can help avoid unnecessary hurdles later on. It is often easier to come to an agreement about the valuation method when forming the company rather than in the heat of the moment when a member decides to exit the business. The operating agreement should also include provisions that detail how a member can resign from the LLC—is member approval required?—and the process for the financial payout for the resigning member’s interest—will it be paid over time or in one lump sum payment?
Death or Disability
The operating agreement should include provisions that address the dissociation of a member by death or disability. The agreement often provides that this event triggers a buy-out of that member’s interest. To make clear how the buy-out will occur, the operating agreement should include details on the valuation method and payout structure. By planning for such an event, your small business can increase the likelihood of a timely resolution of a member’s death or disability.
Removing a Member
The operating agreement should address what happens when there is a serious breach of a member’s obligations to the company. Members may provide for automatic removal of a member if certain events occur that will inevitably harm the business. Members may also choose to allow for removal if a majority (or a specified percentage) of the members vote to expel a member. In the case of expulsion, the operating agreement should provide clear terms for the financial payout to the member that is removed, which is often at a significantly discounted price.
Transfers of LLC Interests
Another common way to exit an LLC is to sell, or transfer, your interest in the business to another person. It’s important to include details in the LLC operating agreement that account for transfers of members’ ownership interests. Transferring a member’s ownership interest can create a number of problems for both the departing member and the remaining members of the business.
Selling members typically want to transfer as many of the management and financial rights as possible in order to collect the greatest profit. However, this generally causes a struggle because the remaining members of the LLC want to restrict management rights of the “new” member as much as possible. Most LLC statutes address this issue. For example, in Washington, a new member, or “assignee,” has no right to participate in management of the LLC unless all members approve or the LLC operating agreement provides for participation in management. Due to the potential for conflicts, it’s important to include provisions in your operating agreement that outline the procedure for transferring ownership interests. Last, the operating agreement should spell out what rights the new member will have, and what approval is required for the new member to participate in managing the company.
Dissolving the LLC
An LLC may be dissolved for a number of reasons: the LLC was formed to exist for a specified duration and that period of time is over; the last remaining member is seeking to exit the company; all members agree to dissolve the LLC; or the LLC may be judicially dissolved by the court or administratively dissolved by the Secretary of State. The LLC operating agreement should include clear details about the process for dissolution, including how the LLC will wind up its affairs—i.e. pay off its creditors and distribute its assets to the remaining owners of the company.
Exiting a company isn’t always easy. In fact, some of the messiest cases I see involve owners trying to exit a small business. And of these cases, most do not have an operating agreement or the operating agreement does not address exit strategies. Deciding on the details of how to exit your small business from the beginning will promote clarity and transparency for you and your business partners.
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