Transfers of Ownership: How Your Operating Agreement Affects Your Ability to Transfer Your Ownership
This is the fifth in a series of blog posts geared towards small business owners outlining the importance of Operating Agreements and explaining the components. To view other blogs in this series, click here.
An LLC's Operating Agreement is the key to a smooth and controlled transition of ownership. While it might seem like a lot of legal jargon, for small business owners, it’s the most important document you can create to protect your company's future. It's the blueprint for how ownership can be transferred, whether a member decides to sell their share or in more difficult circumstances like death or disability.
The Problem with No Plan
Without an Operating Agreement, or with one that is silent on ownership transfers, your business is subject to your state's default rules. These laws can vary, but they often lead to unpredictable and unwanted outcomes. For example, if a member dies, their ownership interest might automatically pass to their heirs. This could mean a spouse or child who has no experience or interest in the business becomes a part-owner, with all the potential for conflict and disruption that entails. Like estate planning for your personal assets, planning what happens to your business in the future may be unpleasant to think about. But not talking about brings a strong risk of dispute (and increased expenses) should you ever wish to leave the business (whether by choice, disability, or death).
The Power of a Buy-Sell Provision
The most critical part of an Operating Agreement for governing ownership transfers is a buy-sell provision, also known as a buyout agreement. This is a legally binding contract among the members that dictates what happens to a member's ownership interest when a "triggering event" occurs.
Common triggering events include:
- A member's death or permanent disability.
- A member's decision to retire or voluntarily leave the business.
- Divorce, bankruptcy, or other legal actions against a member.
A buy-sell agreement provides a clear, predetermined path forward. It can specify that the business or the remaining members have the right or the obligation to purchase the departing member's interest. This is a powerful tool that ensures your business stays in the hands of people you trust.
How a Buy-Sell Agreement Works in Practice
A well-drafted buy-sell provision will address three key areas:
- Transfer Restrictions: This is where you outline the rules for selling ownership. One of the most common and effective tools is a Right of First Refusal (ROFR). A ROFR clause gives the remaining members the first option to purchase a selling member’s interest on the same terms and conditions as a legitimate offer from an outside buyer. This prevents an outsider from suddenly becoming a partner and allows the existing owners to maintain control.
- Valuation: How do you determine the price of an ownership stake? Your Operating Agreement should specify a clear valuation method to avoid future disputes. This could be a fixed price that's updated annually, an appraisal by an independent professional, or a formula based on the company's financials (like a multiple of earnings). A clear, pre-agreed-upon method ensures fairness and reduces the risk of legal battles.
- Funding: A buy-sell agreement is only as good as your ability to fund it. The agreement can outline how the buyout will be paid for, such as using cash reserves, an installment payment plan, or a life insurance policy taken out on each member. Many businesses use life insurance to fund a death buyout, ensuring that the company has the necessary capital to buy out the deceased member's share and provide funds to their heirs without disrupting business operations.
Taking Action to Secure Your Business
Don't wait for a crisis to discover your business has no plan for ownership transitions. By including a comprehensive buy-sell provision in your LLC Operating Agreement, you are taking a crucial step to protect your business and its future. It's a proactive measure that provides clarity, prevents disputes, and ensures that your company can continue to thrive, no matter what happens to its members.
If need legal assistance regarding your LLC’s Operating Agreement, please contact Danielle Dietrich, Esq. at ddietrich@potomaclaw.com or 412-449-9141.
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