Wednesday, February 22, 2012

Why the LLC is a Favorite for Start Ups (Part II)

This post is Part II of a discussion as to why lawyers suggest, and entrepreneurs often prefer, the structure of the limited liability company over other business entities.  While the LLC is relatively new in comparison to the corporation, start-ups more often choose the LLC when forming their business.  Therefore, what is it about the LLC that makes a preferred structure for start-ups?  As explained in the first installment, there are three reasons the LLC has become so prevalent:

          1.  Reason #1: The tax advantages of the LLC versus the corporation;

          2.  Reason #2: The extremely flexible nature of the LLC, allowing wide-latitude in structuring the rights and obligations of the members (i.e., the partners);

          3. Reason #3:  The user friendly nature of an LLC.  

A comparison of the arguable tax advantages of the LLC was the subject of the previous post, while this post focuses on the flexibility of the LLC and the wide-latitude it provides in structuring the rights and obligations of the partners.

Reason #2: The extremely flexible nature of the LLC, allows wide-latitude in structuring the rights and obligations of the members (i.e., the partners).

The document governing the rights and obligations of the members of an LLC is the Operating Agreement.  The key aspect of the Operating Agreement is that it is an extremely flexible document and is limited only by what is expressly prohibited or required by the NY LLCL.  Therefore, the members can utilize the Operating Agreement to structure the economic and control rights to fit the needs of the members and the business.

            A.  Do you want the entity controlled by all the members or a manager?  Under New York law, LLCs are by default deemed member managed, and thus each member has management authority; however, New York law also allows the members to instead choose to have the LLC managed by a manager or a board of managers, and the manager does not need to be a member of the entity.

           B. Do you want all the members to have the same rights?  If not, different classes of members can be created based on voting or economic rights, and in fact some members can be given economic but not voting rights.  Additionally, economic and voting rights need not be based on ownership percentage in the LLC. Contrast this flexibility with an SCorp which prohibits creating different classes of shareholders.  Another alternative is to require super majority or even unanimity for key decisions, leaving the manager to run the day-to-day operations but limiting the authority to protect the rights of minority members when it comes to important substantive issues.

          C.  Do you want to restrict the transfer, pledge or sale of membership interests?  Through the Operating Agreement, the members can elect to include provisions restricting the transfer, pledge or sale of membership interests.  Adding provisions such as a right of first refusal, a co-sale right and a prohibition on the pledge of one's membership interests not only (i) limits the ability of a member to dispose of its interests  without an opportunity for the other members to also monetize, in part, their interests, but also (ii) means the existing members can preclude the admission of a third party who they may decide is not good for the business.

          D. What can be done if I have a dispute with my partner?  The members will have an opportunity when drafting the Operating Agreement to include a Buy/Sell provision addressing the rights of the members if a serious and seemingly unresolvable dispute arises. The Buy/Sell provision should detail the procedure for exercising the right and the methodology employed for valuation of the membership interests. See  In addition, include a clear dispute resolution clause, as you would in any contract, which states the venue for resolving claims both in terms of the type of tribunal (i.e., court, arbitration, mediation) and the actual geographic location (for example, New York County or Nassau County).

         E. What are other examples of what can be included in the Operating Agreement and what are the limitations?  Simply put, the the Operating Agreement can include any provision the members decide to incorporate provided it is not prohibited by the New York Limited Liability Company Law (or is otherwise unlawful).  Therefore, the members may decide to include, among other clauses, (i) a non-compete clause, (ii) confidentiality restrictions, (iii) provisions adjusting the application of certain tax provisions, (iv) provisions relating to the allocation and distribution of profits and losses, (v) grounds for termination of the LLC, expulsion of a member, or addition of new members and (vi) creation of officer positions (such as a President or CFO), to name a few examples of typical Operating Agreement terms. 

       F.  But I have heard that it is harder to raise funds from investors when you have an LLC as opposed to a corporation?  The argument that it is harder to raise funds if you are an LLC as opposed to a corporation does not carry much sway nowadays.  The fact is that it is extremely difficult, even in the best economic environment, to raise financing from third party investors.  If you are fortunate enough to find investors, it is unlikely they would be dissuaded by the fact that the business is an LLC as opposed to a corporation.  Remember, the highly flexible nature of the LLC allows the members to bring in investors with different economic and voting rights, and the LLC is so common place it is rarely a reason investors will be uninterested in your business.   

In sum, the Operating Agreement is a contract among the members of the LLC, and therefore the members have the right to adjust the terms to fit their business needs, reflect the contributions of the members, and make the LLC attractive to potential investors. 

The final installment on this topic will discuss the operational simplicity and ease of use of the LLC. 

Disclaimer:  The discussions in this blog do not constitute legal advise nor create any attorney-client relationship.  You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters.


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