By Cliff Ennico
“My two partners and I started a limited liability company (LLC) a couple of years ago. The business has done great, and we are starting to attract interest from local angel investors.
When we put together the company, the three of us signed a very short Operating Agreement giving us equal shares in the company. With investors coming on board, though, I suspect we will have to start doing things differently. What are some of the things we need to change so that we can bring investors on board but still keep control of the company?”
Whenever an LLC begins to attract investors, the first thing the owners should do is run to the nearest business lawyer and discuss ways in which their organizational documents should be changed, most importantly their LLC Operating Agreement (for you newbies out there, an Operating Agreement is a partnership agreement among the owners or “members” of an LLC).
Here are some of the things you should discuss with your attorney:
Creating a “Board of Managers” to Run the Company. Up to now the three of you have been running the company very informally. It’s time now to create a “Board of Managers” (similar to a corporation’s Board of Directors). The Managers will run the day-to-day operation of the business, with any big decisions being “kicked upstairs” and voted upon by the members. Some LLCs also appoint officers – a President, Vice President, Secretary and Treasurer, just like a corporation – who report to the Managers.
The board should always, always, have an odd number of members (one, three, five, seven, etc.). When a board has an even number of members, there’s the potential for “deadlock”: two members want to go one way, two want to go the opposite way, and the company can’t function because neither faction can muster a majority vote. You want to avoid deadlock at all costs.
Right now, the decision is easy. There are three of you, so all three should be appointed to the board as Managers. The difficulty will come when your investors come on board: they will want to elect an additional member to the board who will look out for their interests, bringing the total number of Managers to four.
If that happens, you should consider giving them two seats on your board. With five total members, there will be no deadlock, and the three “company founders” will remain in control of management.
If that’s not possible, then one of you will need to drop off the board to make room for the investor’s representative. That will be a difficult decision, as the person dropping off the board will no longer be seen as “equal” to the remaining two founders. For that reason, you should draw lots or pick a number out of a hat, so the decision will not reflect on any one individual.
You should also consider adding protections in the Operating Agreement so the founder who is stepping down can’t be abused, harassed or otherwise “oppressed” by the remaining founders or the investors. Your attorney should suggest ways that can be done.
Set Up “Units of Membership Interest”. Right now, each of you owns a one-third “membership interest” in the LLC. With investors coming on board, you should create “units of membership interest” instead.
Units in an LLC function almost exactly the same as shares of stock in a corporation. They don’t change your percentage ownership in the company, but express it another way: instead of owning one-third of the LLC (for example), each of you would own 40,000 units in the LLC, or 120,000 total.
Using units rather than percentages is a little tricky at first, but will make your life a lot easier down the road when the math becomes complicated and unwieldy. An investor will be much happier receiving 10,000 units in an LLC than a 0.826491723% percentage interest.
You can even give your investors “membership certificates”, like stock certificates, which they can hang up on their wall.
Divide Your Units Into “Voting” and “Nonvoting” Classes. Next, divide your units into two classes: nonvoting (the owner has merely the right to receive a percentage of the company’s future profits and losses), and voting (the owner also has the right to vote on certain matters).
A common way to do this is for the LLC Operating Agreement to “authorize” the company to issue up to one million units, with 800,000 designated as voting and 200,000 designated as nonvoting. The Managers (or sometimes the members) would have the ability to issue voting and nonvoting units up to these “ceilings”.
As the founders of this company, the three of you would receive “voting” units. Employees and others who provide services to the company would receive “nonvoting” units. As for your investors, they can receive either, although “big ticket” investors putting more than $100,000 into your company will almost certainly insist on voting units.
More next week . . .
Cliff Ennico (cennico@legalcareer.com) is a syndicated columnist, author and host of the PBS television series ‘Money Hunt’. This column is no substitute for legal, tax or financial advice, which can be furnished only by a qualified professional licensed in your state. To find out more about Cliff Ennico and other Creators Syndicate writers and cartoonists, visit our Web page at www.creators.com. COPYRIGHT 2015 CLIFFORD R. ENNICO. DISTRIBUTED BY CREATORS SYNDICATE, INC. @cliffennico.
