Shotguns, Daggers and Triggers: Escape from LLC Island!

Mar 01, 2016   Print PDF

By Thomas A. Lerner | Related Practices: Business and Financial Services

In January 2016, the new Limited Liability Act becomes effective. It is designed to simplify the process of entity formation even more than is now the case, and offers greater flexibility in the organizational structure. The changes in the Act will require practitioners to review oft-used forms with a critical eye to account for changes in the Act. More customization will be required to take into account the need to clarify the duties among members, managers (if a manager-managed entity) and the entity itself. For example, the statute includes a default duty for a manager not to compete with the entity. Absent provisions in the operating agreement to modify this duty, this could impair the activities of an individual who is the manager of multiple real estate entities.

While the Act makes changes to formation, management and operations, no substantive change has been made to the legal standards governing dissolution of the entity. Dissolution occurs by vote of the members, or after the last member leaves, or by judicial decree. RCW 25.15.275 currently provides:

On application by or for a member or manager the superior courts may decree dissolution of a limited liability company whenever: (1) It is not reasonably practicable to carry on the business in conformity with a limited liability company agreement; or (2) other circumstances render dissolution equitable.
The new Act barely modifies this to include a reference to the certificate of formation in subpart (1). Thus, the basis for dissolution absent the agreement of the members continues to be governed by an intentionally vague standard, with scant past judicial guidance.
The purpose of this article is to suggest that the new LLC Act presents an opportunity to revisit common approaches to deadlocks, departures and dissolution. Just as other common provisions of operating agreements will warrant reconsideration, so should those provisions that address what occurs when the principals of a closely held entity want to go in different directions.
When individuals undertake to form a new business venture, their focus is on moving forward with the business rather than when and how they will separate. After all, at the moment of conception, no one plans for the divorce. Developing a successful business plan is challenging enough. By the time the principals meet with an attorney to discuss entity formation, they are likely already distracted by building the business. Still, diligent counsel will attempt to focus the principals not only on the inevitability of separation but on how to implement that split when the time comes.
The typical LLC Operating Agreement makes it inordinately difficult for the principals to part ways once they conclude that their personal, financial or business goals differ from those of their business partner. In part, this difficulty is intentional—strong constraints on dissolution or separation make it more likely that the parties will work through their differences, allowing the business to continue. Too often, however, the typical structure crosses the line where accomplishing a separation of interests changes from being inconvenient to functionally impossible (or possible, but disastrous). The structure for one member to leave is cumbersome and costly. A seller may suffer from discounted valuations. A buyer may need access to a reservoir of cash to begin the payout, and fund operations. Decisions that could result in an orderly dissolution typically require a supermajority. In a closely held entity, this often translates into a need for unanimity right at the point where fundamental disagreements have crystallized.
In the context of professional associations, a member’s withdrawal may also include noncompete restrictions that could cause someone to relocate. Payouts are substantially deferred and ultimately dependent upon both the success of the entity and the willingness of one’s estranged business partner to prioritize payments to the departed member. The burdens on the continuing member increase while revenue sources diminish, and the payout obligation becomes an added overhead burden. In sum, it can be more onerous to try to start a new life without your business partner than without your spouse.
Knowing this, the attorney preparing the corporate documents will lead the entity members through a variety of options to be included in a buy-sell agreement. Too often, during formation the principals will simply ask the attorney to prepare their “standard form” incorporating the attorney’s recommendations. Those recommendations may only partly be informed by a deep understanding of the principals’ individual and collective interests and their business model. While each of the principals will have been encouraged to confer with their own independent counsel, most choose not to do so. They would rather devote their time and resources to the new business than to hiring more lawyers.
The decisions that confront the entrepreneurs are complex and multilayered. They will often involve considerations that are foreign to the experience of the principals. Should there be restrictions on transfers of membership interests? What is the appropriate scope of those restrictions—and what purposes do those restrictions serve? What exceptions should there be to transfer restrictions—and what interests do the exceptions serve? Should withdrawals be permitted or prohibited? How should member interests be valued in the event of a withdrawal by a member? Should the value of the withdrawing member’s interests change based upon the circumstances of the withdrawal? How should buy-out payments be made, and should the payment obligation be secured and guaranteed?
Valuation of single asset real estate entities can be a fairly simple process, while operating entities have more variables and vulnerabilities, with the potential for adding significantly more expense to the valuation process. Involuntary transfers may lead to discounted sales, with their own unique impacts on valuation, payment and timing. Even a successful real estate venture could be beyond the financial ability of any one member to effectuate a buyout.
Triggers for forced buyouts usually arise in the context of involuntary transfers—typically events extraneous to operations such death, divorce or insolvency of a member—but may also include expulsion of a member by other members of the entity. The classic “dagger” or “shotgun” approach—one names the price and the other chooses to be a buyer or seller at that price—has an elegant simplicity and fairness to it, but in practice may be unaffordable for one or both of the participants. The ability of the purchaser under either formulation may need to secure financing to fund the transaction, just at a time when the entity is going through a period of instability in its management. That will generally make it more difficult to obtain financing.
Perhaps the greatest challenge for lawyers in getting the principals of a new entity to focus on these decisions and their long term importance is the challenge of getting entrepreneurs to slow down. The principals may need to be more carefully educated about the practical realities of what a break-up looks like. When framed that way—how the terms actually work when implemented—may give more meaning to the theoretical explanations that are commonly given. Just as it seems that no individual who signs a personal guaranty ever truly expects to have to answer for it, no entrepreneur begins a business anticipating its end. It is the job of the lawyers to bring more discipline to that thinking.
The primary alternative to this structure is a third-party sale. The typical operating agreement permits a third-party sale, but conditions that sale upon a right of first refusal by the entity and the other members. A potential buyer may be left lingering for months while others evaluate the purchase offer. Then, too, the buyer must come into the existing structure and consent to be bound by the same constraints as the other members. As a practical matter, this structure makes third-party sales as rare as hen’s teeth.
As lawyers who serve as midwives at the birth of these businesses, it is a fair question as to whether our clients are well served by building this ill-fitting infrastructure around them. In practice, very often the parties are confronted with the terms that they have agreed to at the time of business formation—and never revisited—and find that they are thoroughly unworkable at the point of departure. The result is that even in the most amicable setting, the parties find that they are bargaining over a new agreement that is better tailored to their practical reality. The old infrastructure gets set aside. This begs the question of whether the original structure offered much value to begin with.
There is something to be said for the notion that starting a business should be more complicated than leaving one, and that is not now the norm. Should LLC Operating Agreements contain so many obstacles to transfers, or should the process of coming and going be a simpler one? Should the answer to that question depend upon whether the entity is an operating entity or merely holds real estate? If one reduces the barriers to a sale, does that create a disproportionate advantage in favor of the deeper pocketed individual in a “dagger” scenario?
Supermajority requirements, which are typical preconditions for dissolution or fundamental changes to the business, may lead to decisional paralysis. The result is that owners have an illiquid asset, with obstacles to sale and no meaningful exit opportunity. That is a condition that is as likely to foment conflict than avoid it. In short, the obstacles to exit can result in impediments to the continuing success of the business. A business which cannot make major decisions is unlikely to grow.

Consider all this in the context of the common two-member entity, where the members own equal interests. The members are in harmony on a host of issues, and are confident that the future will be no different. For that reason, they omit consideration of a “tie-breaking” mechanism. The result is that when a big decision has to be made, absent an agreement no action gets taken. The company labors on paralyzed from taking action—and paralysis is a brief precursor to demise. This dynamic often leads to evaluation of the mechanisms for exit.

The adoption of a clear and simple tie-breaking mechanism can diminish the risk of conflict and indecision. One commonly suggested tie-breaker is the “phone-a-friend” approach, where the principals agree on presenting the issue to a disinterested third party and ceding the decision-making authority to that third party. Inevitably, the third party will not be as fully informed about the business considerations as the two principals. The third party may (or may not) have in mind the broad array of business considerations that the principals are weighing. Perhaps most importantly, the third-party will not have lived in the business nor walked in the principals shoes as the business decision—and the risks inherent in that decision—are weighed.

Some tie-breaker mechanism should be adopted, rather than have that topic avoided. Let it be a coin-toss, a cut for cards, or taking turns. Rock-paper-scissors is a better tie breaker than no mechanism at all. Consider a “trump card” which allows each member (two member LLC) to weigh whether a particular decision is so important that they will want to control it, or yield ground now and instead control the next key decision over which the members disagree.1

If dissolution by the principals were simpler, might that lead to more cooperative management by owners who otherwise may be in conflict? In short, rather than being trapped inside as being the key to accommodation, may the knowledge that the door is wide open with the attendant disruption from dissolution be a better means of assuring compromise? If one chooses the exit, the buyout opportunities that otherwise exist still remain, and the obstacles to implementation are no greater than when neither party could easily leave. An orderly wind-up may be a better process for the individual who wants to acquire control and carry on the business, and the prospect of a purchase and sale by that means should be a counterweight in negotiations for a buyout of the departing member’s interests. Indeed, consideration should be given as to whether dissolution should be an available remedy on a minority vote or on a deadlock rather than only at the behest of a supermajority.

The advent of the new LLC Act is an opportunity to re-evaluate how lawyers inform, educate and advise clients regarding a host of formation and management issues. It is a good opportunity, too, to bring fresh thinking and discussions not just about the beginnings, but more practical planning for the end.

1  The trump card approach works like this: Each Member shall be issued a virtual “trump card.” For any decisions enumerated as subject to this process, a Member may control the decision by expressly exercising their trump card. Thereafter, the other Member may regain control of the decision by expressly exercising their trump card. The final trump card exercised controls the decision. If both Members have exercised their trump cards, then the Member who no longer controls the decision shall have their trump card restored to them. The Member who controls the decision will not have their trump card restored to them until such later time as the first Member exercises their trump card and controls a decision. No Member may exercise their trump card more than once with regard to any particular decision presented for dispute resolution. Return to article.

Thomas Lerner is a business and financial services litigation attorney. Tom also often works with physicians on business and employment issues.