When setting up a limited liability company (LLC) for a new business, one of the hardest jobs is figuring out how the company should be managed.
In most states, LLCs can be set up in one of two ways, managed either:
* by its owners (called “members”), similar to a general partnership; or
* by one or more managers (who may or may not also be members), similar to a corporation or limited partnership.
Like so many issues in this area, “one size” seldom fits all situations. You and your co-founders must think long and hard about how you will be working together, who will have responsibility for what decisions, who can devote more time to the business than others, and other political issues before you come up with the right solution.
Generally, the “right solution” is a structure that reflects how the company founders will make decisions in real life. Here are some common startup scenarios, and how I normally advise clients in these situations.
Scenario No. 1. The LLC is a tech company formed by three graduate students. The students (being Millennials) all want to be “equal partners.”
I have no problem setting up a member-managed LLC with equal ownership, but in this situation, I would insist on a “supermajority voting provision” in the company’s Operating Agreement requiring the vote of 75 percent or 80 percent of the LLC members to approve any management decision.
That way the members are “joined at the hip” and have to agree on everything. Otherwise, you have an unstable “shifting two-out-of-three majority” where members A and B approve one action, members B and C approve the next, and so forth.
Scenario No. 2. The LLC is an online retailer formed by a U.S. citizen, but with two minority partners based in India and China. The U.S. citizen will be the majority owner and the LLC will be set up in the U.S.
Since the LLC will operate in the U.S., the U.S. citizen should be able to make management decisions with a minimum amount of oversight from his overseas partners. I would set this up as a manager-managed LLC.
The U.S. citizen would be the sole manager with broad and expansive powers. Major decisions (as in Scenario No. 1) would require a “supermajority” vote of the members so that at least one of the foreign partners would have a veto over major decisions such as mergers, venture capital rounds and bankruptcy.
Scenario No. 3. The LLC is a web-based business that wants to attract venture financing. The three founders are family members — a father and two sons. The two sons are going to run the business but the father has all the money and wants to protect his investment in case the business fails.
I would recommend a manager-managed LLC, with all three family members as managers. Yes, the two sons could outvote their father, but as a practical matter, if he doesn’t like being outvoted, he will hold back the money, so there’s an incentive for everyone to be on the same page.
I would also allow this LLC to issue “preferred equity membership interests” (similar to preferred stock in a corporation). The father would make capital contributions to the company either by purchasing preferred shares or lending money to the company via a “convertible note,” which would convert into preferred shares if the company becomes successful (or if a later investor insists the company wipe this “founder debt” off of the books).
Either way, if the company goes under, the father will be able to get his money out before anyone else does — although I wouldn’t want to be invited to this family’s Thanksgiving dinner afterwards.
Scenario No. 4. Two companies want to form an LLC “joint venture” to engage in a particular project. One company will provide the marketing and talent, the other the capital, with management decisions being made jointly.
This will be a manager-managed LLC, but there’s no way to avoid 50/50 ownership of the LLC and a “board of managers” with an even number of members (one or two from each company).
In this situation there needs to be a “deadlock” provision in the company’s Operating Agreement stating clearly and unequivocally what should happen when the two companies disagree on a course of action. I am not a big fan of arbitration clauses, as arbitration these days can cost as much as a court case, and finding an arbitrator who knows what he or she is doing … don’t get me started.
Unless the client has a better idea, I normally include a provision requiring mediation of any dispute with a third-party mediator acceptable to both parties, with a clause requiring the LLC to be dissolved and liquidated if a satisfactory resolution isn’t reached within a reasonable amount of time (say, 90 or 180 days).
Then I sit back and hope and pray the client doesn’t pick me as the mediator.